CA INTERMEDIATE

FINANCIAL MANAGEMENT

“TEST BOOK”

By

CA NAMIT ARORA SIR

“TEST YOUR KNOWLEDGE HERE”

ALL THE BEST

CA. NAMIT ARORA
 TEST BOOK 2

INDEX
S. No. TEST & SOLUTION PAGE NO.

1 EBIT & EPS ANALYSIS 3–8

2 LEVERAGES 9 – 12
3 MANAGEMENT OF RECEIVABLES & PAYABLES 13 – 15
4 MANAGEMENT OF WORKING CAPITAL 16 – 20
5 TREASURY AND CASH MANAGEMENT 21 – 24
6 RATIO ANALYSIS 25 – 29
7 INVESTMENT DECISIONS OR CAPITAL BUDGETING 30 – 34
8 COST OF CAPITAL 35 – 39
9 CAPITAL STRUCTURE 40 – 43
10 DIVIDEND DECISIONS 44 – 46
11 50 MARKS SAMPLE PAPER 1 47 – 54
12 50 MARKS SAMPLE PAPER 2 55 – 61
 TEST BOOK 3
TEST 1 – EBIT & EPS ANALYSIS
Question 1

The following data are presented in respect of Quality Automation Ltd.:

Particulars `
Profit before interest and tax 52,00,000
Less: Debenture interest @ 12% 12,00,000
Profit before tax 40,00,000
Less: Income tax @ 50% 20,00,000
Profit after tax 20,00,000
No. of Equity Shares (`10 each) 8,00,000
Earning per share (EPS) `2.50
Price Earning (PE) Ratio, 10
Market Price Per Share `25.00

The company is planning to start a new project requiring a total capital outlay of `40,00,000. You are
informed that a debt equity ratio (D/D+E) higher than 35% push the Ke up to 12.5% means reduce PE ratio to
8 and rises the interest rate on additional amount borrowed at 14%.

Find out the probable price of share if:

(1) The additional funds are raised as a loan.

(2) The amount is raised by issuing equity shares.

(Note: Retained earnings of the company is `1.2 crore)

(10 Marks)

Question 2

Ganapati Limited is considering three financing plans. The key information is as follows:

(a) Total investment to be raised `2,00,000.

(b) Financing proportion of Plans:

Plans Equity Debt Preference Shares

A 100% - -
B 50% 50% -
C 50% - 50%

(c) Cost of debt is 8%

Cost of preference shares is 8%
(d) Tax rate 50%
(e) Equity shares of the face value of `10 each will be issued at a premium of `10 per share
(f) Expected EBIT is `80,000.

You are required to determine for each plan:

(1) Earnings per share

(2) Financial break-even-point
(3) Indicate if any of the plans dominate and compute the EBIT range among the plans for indifference.

(10 Marks)
 TEST BOOK 4
Question 3

A Company earns a profit of `3,00,000 per annum after meeting its interest liability of `1,20,000 on 12%
debentures. The Tax rate is 50%. The number of Equity Shares of `10 each are 80,000 and the retained
earnings amount to `12,00,000. The company proposes to take up an expansion scheme for which a sum of
`4,00,000 is required.

It is anticipated that after expansion, the company will be able to achieve the same return on
investment as at present. The funds required for expansion can be raised either through debt at the rate of
12% or by issuing Equity Shares at par.

Required:

(i) Compute the Earnings Per Share (EPS), if:

(a) The additional funds were raised as debt
(b) The additional funds were raised by issue of equity shares.

(ii) Advise the company as to which source of finance is preferable.

(6 Marks)

Question 4

RM Steels Limited requires `10,00,000 for the construction of new plant. It is considering three financial plans:

(1) The Company may issue 1,00,000 ordinary shares at `10 per share.
(2) The Company may issue 50,000 ordinary shares at `10 per share and 5,000 debentures of `100
denomination bearing 8% rate of interest.
(3) The Company may issue 50,000 ordinary shares at `10 per share and 5,000 preference shares at `100
per share bearing a 8% rate of dividend.

If RM Steels Limited’s earnings before interest and taxes are `20,000, `40,000, `80,000, `1,20,000 and
`2,00,000. Tax rate is 50%.

You are required to compute the earning per share under each of the three plans? Which alternative
would you recommend for RM Steels and why?

(10 Marks)
 TEST BOOK 5
SOLUTION TEST 1
Solution 1
Statement of Market Value Per Share (MPS)

Particulars Debt Plan Equity Plan

EBIT @ 17.⅓% of 3,40,00,000 (3,00,00,000 + 40,00,000) 58,93,333 58,93,333
Less: Interest: Existing 12,00,000 12,00,000
New (14% of `40,00,000) 5,60,000 -
EBT 41,33,333 46,93,333
Less: Tax @ 50% 20,66,667 23,46,667
PAT 20,66,666 23,46,666
÷ No. of Equity shares 8,00,000 9,60,000
EPS `2.583 `2.444
× PE Ratio 8 Times 10 Times
MPS `20.66 `24.44

Note: In this question EBIT after proposed extension is not given. Therefore, we can assume that existing
return on capital employed will be maintained.

Working notes:

1. Calculation of capital employed before expansion plan:

Equity share capital (8,00,000 shares × `10) `80,00,000

Retained earnings `1,20,00,000
Debentures (12,00,000/12%) `1,00,00,000
Total capital employed `3,00,00,000

2. Return on Capital Employed (ROCE):

EBIT 52 ,00 ,000

ROCE = × 100 = × 100 = 17.⅓%
Capital Employed 3,00 ,00 ,000

3. Debt Equity Ratio if `40,00,000 is raised as Debt:

1 ,40 ,00 ,000 (1 ,00 ,00 ,000 + 40 ,00 ,000 )

= × 100 = 41.18%
3,40 ,00 ,000 (3,00 ,00 ,000 + 40 ,00 ,000 )

As the debt equity ratio is more than 35% the P/E ratio will be brought down to 8 in Plan 1

4. Debt Equity Ratio if `40,00,000 is raised as Equity:

1 ,00 ,00 ,000

= × 100 = 29.41%
3 ,40 ,00 ,000

As the debt equity ratio is less than 35% the P/E ratio in this case will remain at 10 times in Plan 2.

5. Number of Equity Shares to be issued in Plan 2:

40 ,00 ,000
= = 1,60,000 shares
25

Decision: Though loan option has higher EPS but equity option has higher MPS therefore company should raise
additional fund through equity option.
 TEST BOOK 6
Solution 2
(1) Statement of EPS

Alternatives
Particulars
A B C
Earnings before interest and tax 80,000 80,000 80,000
Less: Interest @ 8% on `1,00,000 - 8,000 -
EBT 80,000 72,000 80,000
Less: Tax @ 50% 40,000 36,000 40,000
EAT 40,000 36,000 40,000
Less: Preference Dividend @ 8% on `1,00,000 - - 8,000
Earning Available for Equity Shareholders 40,000 36,000 32,000
÷ No. of Equity shares (Issue price `20) 10,000 5,000 5,000
EPS `4.00 `7.20 `6.40

(2) Financial Break Even Point (EBIT equals to fixed financial cost):

Proposal A Financial B.E.P. = No Fixed Financial Cost = Zero

Proposal B Financial B.E.P. = Interest on Debt = 8,000

Pr eference Dividend
Proposal C Financial B.E.P. =
(1  t )
8,000
= 1 − 0.50
= 16,000

(3) Indifference Point:

Between Proposal A & B:

(EBIT−I) (1−T) (EBIT−I) (1−T)

NA
= NB

(EBIT−0) (1−0.50) (EBIT−8,000) (1−0.50)

10,000
= 5,000

EBIT = `16,000

Between Proposal A & C:

(EBIT−I) (1−T) {(EBIT−I) (1−T) − PD}
=
NA NC

(EBIT−0) (1−0.50) {(EBIT−0) (1−0.50) − 8,000}

10,000
= 5,000

EBIT = `32,000

Between Proposal B & C:

(EBIT−I) (1−T) {(EBIT−I) (1−T) − PD}

NB
= NC

(EBIT−8,000) (1−0.50) {(EBIT−0) (1−0.50) − 8,000}

5,000
= 5,000

0.5 EBIT – 4,000 ≠ 0.5 EBIT – 8,000

There is no indifference point between the financial plans B and C. It can be seen that Financial Plan B
dominates Plan C. Since, the financial break-even point of the former is only `8,000 but in case of latter it is
`16,000.
 TEST BOOK 7
Solution 3
(i) Statement of EPS
Alternatives
Particulars
Debt Plan Equity Plan
Earnings before interest and tax @ 14% of `34,00,000 4,76,000 4,76,000
Less: Interest:
Existing 1,20,000 1,20,000
New (12% on `4,00,000) 48,000 -
EBT 3,08,000 3,56,000
Less: Tax @ 50% 1,54,000 1,78,000
EAT 1,54,000 1,78,000
÷ No. of Equity shares
Existing 80,000 80,000
New - 40,000
EPS `1.925 `1.483

(ii) Advise to the company: Since EPS is greater in the case when company arranges additional funds as
debt. Therefore, the company should finance the expansion scheme by raising debt.

Working notes:

1. Calculation of capital employed before expansion plan:

Equity share capital `8,00,000
Retained earnings `12,00,000
Debentures (1,20,000/12%) `10,00,000
Total capital employed `30,00,000

2. Earnings before the payment of Interest and tax (EBIT):

Profit before tax `3,00,000
Interest `1,20,000
EBIT `4,20,000

3. Return on Capital Employed (ROCE):

EBIT 4 ,20 ,000

ROCE = × 100 = × 100 = 14%
Capital Employed 30 ,00 ,000

4. After expansion capital employed = `34,00,000 (`30,00,000 + `4,00,000)

Solution 4

1. Statement showing EPS with respect to various plans & different EBIT:

a. Equity Financing

Particulars ` ` ` ` `
EBIT 20,000 40,000 80,000 1,20,000 2,00,000
Less: Interest 0 0 0 0 0
EBT 20,000 40,000 80,000 1,20,000 2,00,000
Less: Tax @ 50% (10,000) (20,000) (40,000) (60,000) (1,00,000)
EAT 10,000 20,000 40,000 60,000 1,00,000
÷ No. of Equity Shares ÷ 1,00,000 ÷ 1,00,000 ÷ 1,00,000 ÷ 1,00,000 ÷ 1,00,000
EPS `0.10 `0.20 `0.40 `0.60 `1.00
 TEST BOOK 8
b. Debt - Equity Mix

Particulars ` ` ` ` `
EBIT 20,000 40,000 80,000 1,20,000 2,00,000
Less: Interest (40,000) (40,000) (40,000) (40,000) (40,000)
EBT (20,000) 0 40,000 80,000 1,60,000
Less: Tax @ 50% *10,000 0 (20,000) (40,000) (80,000)
EAT (10,000) 0 20,000 40,000 80,000
÷ No. of Equity Shares ÷ 50,000 ÷ 50,000 ÷ 50,000 ÷ 50,000 ÷ 50,000
EPS (`0.20) `0.00 `0.40 `0.80 `1.60

*10,000 is the tax saving in case of loss.

c. Preference Share - Equity Mix

Particulars ` ` ` ` `
EBIT 20,000 40,000 80,000 1,20,000 2,00,000
Less: Interest 0 0 0 0 0
EBT 20,000 40,000 80,000 1,20,000 2,00,000
Less: Tax @ 50% (10,000) (20,000) (40,000) (60,000) (1,00,000)
EAT 10,000 20,000 40,000 60,000 1,00,000
Less: Preferential Dividend **(40,000) **(40,000) (40,000) (40,000) (40,000)
EAT after Pref. Dividend (30,000) (20,000) 0 20,000 60,000
÷ No. of Equity Shares ÷ 50,000 ÷ 50,000 ÷ 50,000 ÷ 50,000 ÷ 50,000
EPS (`0.60) (`0.40) `0.00 `0.40 `1.20

**In case of cumulative preference shares, the company has to pay cumulative dividend to preference
shareholders, when company earns sufficient profits, so deducted here even in case of insufficient profit to
reach right decision.

2. Recommendation:

(a) If expected EBIT is less than `80,000 : Equity Finance (Alternative 1)

(b) If expected EBIT is equal to `80,000 : Equity or Debt - Equity Mix (Alternative 1 or 2)
(c) If expected EBIT is more than `80,000 : Debt – Equity Mix (Alternative 2)
 TEST BOOK 9
TEST 2 – LEVERAGES
Question 1

Details of a company for the year ended 31st March, 2022 are given below:

Sales : `86,00,000
Profit Volume (P/V) Ratio : 35%
Fixed Cost excluding interest expense : `10,00,000
10% Debt : `55,00,000
Equity Share Capital of `10 each : `75,00,000
Income Tax Rate : 40%

Required:
(1) Determine company’s Return on Capital Employed (Pre-tax) and EPS.
(2) Does the company have a favourable financial leverage?
(3) Calculate operating and combined leverage of the company.
(4) Calculate percentage change in EBIT, if sales increases by 10%
(5) At what level of sales, the Earning before tax (EBT) of the company will be equal to zero?
(10 Marks)

Question 2

The balance sheet of Gitashree Ltd. is given below:

Liabilities ` Assets `
Equity Share Capital 1,80,000 Net Fixed Assets 4,50,000
(`10 per share) Current Assets 1,50,000
Retained Earning 60,000
10% Long Term Debt 2,40,000
Current Liabilities 1,20,000
6,00,000 6,00,000

The company's total assets turnover ratio is 4 times, its fixed operating cost is `2,00,000 and its
variable operating cost ratio is 60%. The income tax rate is 30%.

You are required to:

1. (a) Degree of Operating Leverage.

(b) Degree of Financial Leverage.
(c) Degree of Combined Leverage.

2. Determine the likely level of EBIT if EPS is (A) `1.00, (B) `2.00 and (C) `Nil.
(10 Marks)

Question 3

The following particulars relating to Navya Ltd. for the year ended 31st March 2023 is given:

Output 1,00,000 units at normal capacity

Selling price per unit `40
Variable cost per unit `20
Fixed cost `10,00,000

The capital structure of the company as on 31st March, 2023 is as follows:

 TEST BOOK 10
Particulars `
Equity share capital (1,00,000 shares of `10 each) 10,00,000
Reserves and surplus 5,00,000
7% Debentures 10,00,000
Current liabilities 5,00,000
Total 30,00,000

Navya Ltd. has decided to undertake an expansion project to use the market potential, that will involve `10
lakhs. The company expects an increase in output by 50%. Fixed cost will be increased by `5,00,000 and
variable cost per unit will be decreased by 10%. The additional output can be sold at the existing selling price
without any adverse impact on the market.

The following alternative schemes for financing the proposed expansion programme are planned:

(1) Entirely by equity shares of `10 each at par.

(2) `5 lakh by issue of equity shares of `10 each and the balance by issue of 6% debentures of `100 each
at par.
(3) Entirely by 6% debentures of `100 each at par.

Find out which of the above-mentioned alternatives would you recommend for Navya Ltd. with
reference to the risk and return involved, assuming a corporate tax of 40%.

(10 Marks)
 TEST BOOK 11
SOLUTION TEST 2
Solution 1

EBIT 20 ,10 ,000

(1) ROCE = ×100 = ×100 = 15.46%
Capital Employed 55,00 ,000  75,00 ,000

Statement of EPS
Particulars `
Sales 86,00,000
Less: Variable cost @ of 65% (100 – P/V ratio) of sales 55,90,000
Contribution 30,10,000
Less: Fixed costs 10,00,000
EBIT 20,10,000
Less: Interest @ 10% of 55,00,000 5,50,000
EBT 14,60,000
Less: Income Tax @ 40% 5,84,000
EAT 8,76,000
÷ Number of Equity Shares ÷ 7,50,000
EPS 1.168

(2) ROCE is 15.46% and Interest on debt is 10%, hence, it has a favourable financial leverage.

(3) Calculation of Operating and Combined leverages:

Contributi on 30 ,10 ,000
Operating Leverage = = = 1.497
EBIT 20 ,10 ,000

Contributi on 30 ,10 ,000

Combined Leverage = = = 2.062
EBT 14 ,60 ,000

(4) Operating leverage is 1.497. So if sales is increased by 10% then EBIT will be increased by 1.497 × 10
i.e. 14.97% (approx.)

(5) EBT = Sales – Variable cost – Fixed cost – Interest

Nil = Sales – 65% sales – 10,00,000 – 5,50,000
35% of sales = 15,50,000
Sales = `44,28,571

Solution 2

Contributi on 9 ,60 ,000

1. (a) Operating Leverage = = = 1.26
EBIT 7 ,60 ,000

EBIT 7 ,60 ,000

(b) Financial Leverage = = = 1.03
EBT 7 ,36 ,000

(c) Combined Leverage = OL × FL = 1.26 × 1.03 = 1.30

2. Calculation of likely level of EBIT:

(EBIT − I) (1 − t)
Earnings Per Share = N

(EBIT − 24,000) (1 − 0.30)

Case A: `1.00 = or EBIT = `49,714
18,000
(EBIT − 24,000) (1 − 0.30)
Case B: `2.00 = or EBIT = `75,429
18,000
 TEST BOOK 12
(EBIT − 24,000) (1 − 0.30)
Case C: `0.00 = 18,000
or EBIT = `24,000

Working Note:
Income Statement
Particulars `
Sales (4 times of 6,00,000) 24,00,000
Less: Variable Cost @ 60% of 24,00,000 14,40,000
Contribution 9,60,000
Less: Fixed Cost 2,00,000
EBIT 7,60,000
Less: Interest @ 10% of 2,40,000 24,000
EBT 7,36,000

Solution 3
Statement Showing Profitability of Alternative Schemes for Financing

Particulars Existing Alt 1 Alt 2 Alt 3

Production (in units) 1,00,000 1,50,000 1,50,000 1,50,000
Sales value @ `40 per unit 40,00,000 60,00,000 60,00,000 60,00,000
Less: Variable cost @ `20/ `18 per unit 20,00,000 27,00,000 27,00,000 27,00,000
Contribution 20,00,000 33,00,000 33,00,000 33,00,000
Less: Fixed cost 10,00,000 15,00,000 15,00,000 15,00,000
EBIT 10,00,000 18,00,000 18,00,000 18,00,000
Less: Interest on loan: 70,000 70,000 70,000
Existing @ 7% of `10,00,000 70,000 - 30,000 60,000
New @ 6% of `5/`10 Lakh -
EBT 9,30,000 17,30,000 17,00,000 16,70,000
Less: Tax @ 40% (3,72,000) (6,92,000) (6,80,000) (6,68,000)
EAT 5,58,000 10,38,000 10,20,000 10,02,000
÷ Number of Equity Shares (Existing + New) ÷ 1,00,000 ÷ 2,00,000 ÷ 1,50,000 ÷ 1,00,000
EPS `5.58 `5.19 `6.80 `10.02
Operating leverage (Contribution ÷ EBIT) 2.00 1.83 1.83 1.83
Financial Leverage (EBIT ÷ EBT) 1.08 1.04 1.06 1.08
Combined Leverage (Contribution ÷ EBT) 2.15 1.91 1.94 1.98
Lower than
Risk - Lowest Highest
Alt 3
Lower than
Return - Lowest Highest
Alt 3

From the above figures, we can see that the Operating Leverage is same in all alternatives though Financial
Leverage differs. Alternative (3) uses the maximum amount of debt and result into the highest degree of
financial leverage, followed by alternative (2). Accordingly, risk of the company will be maximum in these
options. Corresponding to this scheme, however, maximum EPS (i.e., `10.02 per share) will be also in option
(3).
So, if Navya Ltd. is ready to take a high degree of risk, then alternative (3) is strongly recommended. In
case of opting for less risk, alternative (2) is the next best option with a reduced EPS of `6.80 per share. In case
of alternative (1), EPS is even lower than the existing option, hence not recommended.
 TEST BOOK 13
TEST 3 – MANAGEMENT OF RECEIVABLES & PAYABLES
Question 1

A trader whose current sales are in the region of `6 lakhs per annum and an average collection period of 30
days wants to pursue a more liberal policy to improve sales. A study made by a management consultant reveals
the following information:

Increase in Collection Present default

Credit Policy Increase in Sales
Period anticipated
A 10 days `30,000 1.5%
B 20 days `48,000 2%
C 30 days `75,000 3%
D 45 days `90,000 4%

The selling price per unit is `3. Average cost per unit is `2.25 and variable costs per unit are `2. The current
bad debt loss is 1%. Required return on additional investment is 20%. Assume a 360 days year.

Analyse which of the above policies would you recommend for adoption?
(10 Marks)

Question 2

A regular customer of your company has approached to you for extension of a credit facility for enabling them
to purchase goods. On an analysis of past performance and on the basis of information supplied, the following
pattern of payment schedule emerges:
Pattern of Payment Schedule
At the end of 30 Days 20% of the bills
At the end of 60 Days 30% of the bills
At the end of 90 Days 30% of the bills
At the end of 100 Days 18% of the bills
Non-recovery 2% of the bills

The customer wants to enter into a firm commitment for purchase of goods of `30 Lacs in 2023,
deliveries to be made in equal quantities on the first day of each quarter in the calendar year. The price per
unit of commodity is `300 on which a profit of `10 per unit is expected to be made. It is anticipated that taking
up of this contract would mean an extra recurring expenditure of `10,000 per annum.

If the opportunity cost is 18% per annum, would you as the finance manager of the company
recommend the grant of credit to the customer? Assume year of 360 days.
(10 Marks)

Question 3

A Ltd. has a total sale of `6.4 crores and its average collection period is 90 days. The past experience indicates
that bad debt losses are 1.5% on sales.

The expenditure incurred by the firm in administering its receivable collection efforts is `10,00,000. A
factor is prepared to buy the firm’s receivables by charging 2% commissions.

The factor will pay advance on receivables to the firm at an interest rate of 18% p.a. after withholding
10% as reserve.

(1) Calculate the effective cost of factoring to the firm (360 Days in a year),
(2) If bank finance for working capital is available at 14% interest, should the firm avail of factoring
service?
 TEST BOOK 14
SOLUTION TEST 3
Solution 1

Statement of Evaluation of Credit Policies

Particulars Existing A B C D
No of units 2,00,000 2,10,000 2,16,000 2,25,000 2,30,000
Credit sales @ `3 per unit 6,00,000 6,30,000 6,48,000 6,75,000 6,90,000
Less: Variable cost @ `2 per unit 4,00,000 4,20,000 4,32,000 4,50,000 4,60,000
Less: Fixed cost (2.25 - 2) × 2,00,000 50,000 50,000 50,000 50,000 50,000
Profit before bad debt losses 1,50,000 1,60,000 1,66,000 1,75,000 1,80,000
Less: Bad debt losses 6,000 9,450 12,960 20,250 27,600
Expected Profit 1,44,000 1,50,550 1,53,040 1,54,750 1,52,400
Less: Required return on investment 7,500 10,444 13,389 16,667 21,250
Net Benefit 1,36,500 1,40,106 1,39,651 1,38,083 1,31,150

Recommendation: The Proposed Policy A (i.e. increase in collection period by 10 days or total 40 days) should
be adopted since the net benefits under this policy are higher as compared to other policies.

Working notes:

Calculation of cost required rate of return:

Collection Period
Required rate of return = Total cost × × Rate of return
360 Days
30
Existing Policy = 4,50,000 × × 20% = 7,500
360 Days
40
Credit Policy A = 4,70,000 × × 20% = 10,444
360 Days
50
Credit Policy B = 4,82,000 × × 20% = 13,389
360 Days
60
Credit Policy C = 5,00,000 × × 20% = 16,667
360 Days
75
Credit Policy D = 5,10,000 × × 20% = 21,250
360 Days

Solution 2
Statement of Evaluation of Credit Policy
Particulars Proposed
Sales in units 10,000
Sales value @ `300 per unit 30,00,000
Less: Variable cost @ `290 per unit 29,00,000
Less: Extra recurring expenditure 10,000
Profit before bad debt 90,000
Less: Bad debts @ 2% 60,000
Expected Profit 30,000
Less: Opportunity cost of investment in receivables (WN) 1,00,395
Net Benefit (70,395)

Recommendation: The proposed policy should not be adopted since the net benefit under this policy is
negative.

Working notes:
Calculation of Opportunity cost of average investment:
 TEST BOOK 15
Average Collection Period
Opportunity cost = Total cost × × Rate
360
= 29,10,000 × 69/360 × 18% = 1,00,395

Calculation of Average collection period:

Average collection period = 30 days × 20% + 60 days × 30% + 90 days × 30% + 100 days × 18%
= 69 Days

Solution 3
(1) Statement of Effective Cost of Factoring to the Firm

Particulars `
(1) Cost of factoring:
Factoring commission (3,20,000 × 360 Days/90 Days) 12,80,000
Interest charges (6,33,600 × 360 Days/90 Days) 25,34,400

Total (1) 38,14,400

(2) Savings:
Saving in credit administration cost 10,00,000
Saving in bad debts (1.5% of 6,40,00,000) 9,60,000

Total (2) 19,60,000

Effective cost of factoring (1 - 2) 18,54,400

Rate of effective cost  

18 ,54 ,400 13.79%
100 
 1 ,34 ,46 ,400 

Working Notes:
Calculation of advance:
Particulars `
Average receivables (6,40,00,000 × 90/360) 1,60,00,000
Less: Factor reserve @ 10% of 1,60,00,000 16,00,000
Maximum possible advance 1,44,00,000
Less: Commission @ 2% of 1,60,00,000 3,20,000
Amount available for advance 1,40,80,000
Less: Interest (1,40,80,000 × 18% × 90/360) 6,33,600
Amount of advance 1,34,46,400

(2) If bank finance for working capital is available at 14%, firm should avail factoring service at 13.79%
which is lower than bank interest.

Note: Alternatively rate of effective cost also can be calculated by some authors on amount avail for advance
(1,40,80,000).
 TEST BOOK 16
TEST 4 – MANAGEMENT OF WORKING CAPITAL
Question 1

Following information is forecasted by the CS Limited for the year ending 31st March 2023:

Bal as at 01.04.22 Bal as at 31.03.23

Raw Material 45,000 65,356
Work-in-process 35,000 51,300
Finished goods 60,161 70,175
Receivables 1,12,123 1,35,000
Payables 50,079 70,469
Annual purchases of raw materials (all credit) 4,00,000
Annual cost of production 7,50,000
Annual cost of goods sold 9,15,000
Annual operating cost 9,50,000
Sales (all credit) 11,00,000
You may take one year as equal to 365 days

You are required to calculate:

(i) Net operating cycle period.

(ii) Number of operating cycles in the year.
(iii) Amount of working capital requirement.
(10 Marks)

Question 2

PQ Ltd. a company newly commencing business in 2023 has the under-mentioned projected P & L Account:

Particulars ` `
Sales 2,10,000
Cost of goods sold 1,53,000
Gross Profit 57,000
Administrative Expenses 14,000
Selling Expenses 13,000 27,000
Profit Before Tax 30,000
Provision for taxation 10,000
Profit After Tax 20,000

The cost of goods sold has been arrived at as under:

Materials used 84,000

Wages and manufacturing Expenses 62,500
Depreciation 23,500
Cost of Finished Goods Produced 1,70,000
Less: Stock of Finished Goods 17,000
(10% of goods produced not yet sold) 1,53,000

The figure given above relate only to finished goods and not to work-in-progress. Goods equal to 15%
of the year’s production (in terms of physical units) will be in process on the average requiring full materials
but only 40% of the other expenses. The company believes in keeping materials equal to two months
consumption in stock.

All expenses will be paid one month in advance. Suppliers of materials will extend 1-½months credit.
Sales will be 20% for cash and rest at two months credit. 70% of the income tax will be paid in advance in
quarterly installments. The company wishes to keep `8,000 in cash. 10% has to be added to the estimated
 TEST BOOK 17
figure for unforeseen contingencies.

Prepare an estimate of working capital on cash cost basis.

(10 Marks)

Question 3

The management of MNP Company Ltd. is planning to expand its business and consult you to prepare an
estimated working capital statement.

The records of the company revealed the following annual information:

Sales:
Domestic at one month’s credit `24,00,000
Export at three month’s credit `10,80,000
(Sales price 10% below Domestic price)
Material used (suppliers extend two months credit) `9,00,000
Lag in payment of wages - ½ month `7,20,000
Lag in payment of manufacturing expenses (cash) - 1 month `10,80,000
Lag in payment of administrative expenses - 1 month `2,40,000
Sales promotion expenses payable quarterly in advance `1,50,000
Income tax payable in four installments (of which one falls in the next financial year)`2,25,000

Rate of gross profit is 20%. Ignore work-in-progress and depreciation. The company keeps one
month’s stock of raw materials and finished goods (each) and believes in keeping `2,50,000 available to it
including the overdraft limit of `75,000 not yet utilized by the company. The management is also of the opinion
to make 12% margin for contingencies on computed figure.

You are required to prepare the estimated working capital statement for next year.
(10 Marks)

Question 4

The following information is provided by MNP Ltd. for the year ending 31st March, 2023:

Raw material storage period 45 days

Work-in progress conversion period 20 days
Finished Goods storage period 25 days
Debt collection period 30 days
Creditor’s payment period 60 days
Annual Operating cost (including depreciation of `2,50,000) `25,00,000
Assume 360 days in a year.

You are required to calculate:

I. Operating Cycle period.

II. Number of Operating Cycle in a year.
III. Amount of working capital required of the company on a cash cost basis.
IV. The company is a market leader in its product, there is virtually no competitor in the market. Based on
a market survey it is planning to discontinue sales on credit and deliver products based on pre-
payment in order to reduce its working capital requirement substantially. You are required to compute
the reduction in working capital requirement in such a scenario.
(5 Marks)
 TEST BOOK 18
SOLUTION TEST 4
Solution 1

(i) Operating cycle = R+W+F+D–C

= 53 + 21 + 26 + 41 – 55 = 86 Days

Calculations:

Average stock of raw materials

Raw materials storage period (R) =
Average cos t of raw materials consumptio n per day
55 ,178
= = 53 days
3 ,79 ,644  365

Raw materials consumption = Opening RM + Purchases – Closing RM

= 45,000 + 4,00,000 – 65,356 = 3,79,644

Average stock of WIP

WIP holding period =
Average cos t of production per day
43 ,150
= = 21 days
7 ,50 ,000  365

Average stock of FG
Finished Goods storage period =
Average cos t of goods sold per day
65 ,178
= = 26 days
9 ,15 ,000  365

Average book debts

Debtors collection period =
Average credit sales per day
1 ,23 ,562
= = 41 days
11 ,00 ,000  365

Average trade creditors

Credit period availed =
Average credit purchases per day
60 ,274
= = 55 days
4 ,00 ,000  365
Calculation of averages:
1. Average stock of raw materials = (45,000 + 65,356) ÷ 2 = 55,178
2. Average stock of WIP = (35,000 + 51,300) ÷ 2 = 43,150
3. Average stock of FG = (60,181 + 70,175) ÷ 2 = 65,178
4. Average receivables = (1,12,123 + 1,35,000) ÷ 2 = 1,23,562
5. Average payables = (50,079 + 70,469) ÷ 2 = 60,274

(ii) Number of operating cycles in the year:

365 365
= = 4.244 times
Operating cycle period 86

(iii) Amount of working capital required:

Annual operating cos t 9 ,50 ,000

= = `2,23,845 Or
Number of operating cycles 4.244

Annual operating cos t 9 ,50 ,000

× Operating cycle period = × 86 = `2,23,836
365 365
 TEST BOOK 19
Solution 2
Statement of Working Capital Requirement
Particulars `
(1) Current Assets:
Raw materials (96,600 × 2/12) 16,100
Work in progress 16,350
Finished goods 14,650
Debtors (1,58,850 × 80% × 2/12) 21,180
Prepaid expenses:
Wages and Manufacturing Expenses (66,250 × 1/12) 5,521
Administrative Expenses (14,000 × 1/12) 1,167
Selling Expenses (13,000 × 1/12) 1,083
Advance tax paid [(70% of 10,000) × 3/12] 1,750
Cash 8,000
Total (1) 85,801
(2) Current Liabilities:
Creditors (96,600 + 16,100) × 1.5/12 14,088
Provision for Tax (Net of Advance Tax) (10,000 × 30%) 3,000
Total (2) 17,088
Working Capital Before Provision(1 - 2) 68,713
Add : Provision for Contingencies @ 10% of 68,713 6,871
Working Capital Including Provision 75,584

Working Notes:
Projected Income Statement
Particulars `
Raw Materials (84,000 + 15%) 96,600
Wages and Manufacturing Expenses (62,500 + 15% of 62,500 × 40%) 66,250
Cost Upto Factory 1,62,850
Less: Closing WIP (84,000 × 15%) + (15% of 62,500 × 40%) (16,350)
Cost of Production 1,46,500
Less: Closing FG (10% of 1,46,500) (14,650)
Cost of Goods Sold 1,31,850
Administrative Expenses 14,000
Selling Expenses 13,000
Cash Cost of Sales 1,58,850

Solution 3
Statement of Working Capital Requirement (Cash Cost Basis)
Particulars `
(A) Current Assets:
Raw Materials (9,00,000 × 1/12) 75,000
Finished Goods (29,40,000 × 1/12) 2,45,000
Debtors:
Domestic (19,60,000 + 1,03,448) × 1/12 1,71,954
Export (9,80,000 + 46,552) × 3/12 2,56,638
Cash (2,50,000 – 75,000) 1,75,000
Prepaid Sales Promotion Expenses (1,50,000 × 1/4) 37,500
Total (A) 9,61,092
(B) Current Liabilities:
Creditors (9,00,000 × 2/12) 1,50,000
Outstanding labour (7,20,000 × 0.5/12) 30,000
Outstanding Manufacturing Expenses (10,80,000 × 1/12) 90,000
Outstanding Administrative Expenses (2,40,000 × 1/12) 20,000
Income Tax Payable (2,25,000 × 1/4) 56,250
Total (B) 3,46,250
 TEST BOOK 20
Working Capital Before Provision (A - B) 6,14,842
Add : Safety Margin @ 12% of 6,14,842 73,781
Working Capital 6,88,623

Working Notes:

1. Calculation of Cash cost of Debtors:

Export sales (10% below domestic sales price) = 10,80,000

Export sales equivalent to domestic sales = 10,80,000 × 100 = 12,00,000

90
Total equivalent domestic sales = 24,00,000 + 12,00,000 = 36,00,000

Apportionment of cash cost of sales except sales promotion expenses in proportion of equivalent domestic
sales between Domestic and Foreign Sales:

Domestic sales = 29,40,000 × 24 ,00 ,000 = 19,60,000

36 ,00 ,000
Foreign sales = 29,40,000 × 12 ,00 ,000 = 9,80,000
36 ,00 ,000

Apportionment of sales promotion expenses between Domestic and Foreign Sales in sales ratio:

Domestic sales = 1,50,000 × 24 ,00 ,000 = 1,03,448

34 ,80 ,000
Foreign sales = 1,50,000 × 10 ,80 ,000 = 46,552
34 ,80 ,000

2. Projected Income Statement

Particulars `
Raw Materials 9,00,000
Wages 7,20,000
Manufacturing Expenses (in cash) 10,80,000
Administration Expenses (in cash) 2,40,000
Cash Cost of Goods Sold 29,40,000
Sales Promotion Expenses (in cash) 1,50,000
Cash Cost of Sales 30,90,000

Assumption: Administrative expenses is related to production.

Solution 4

I. Operating cycle = R+W+F+D–C

= 45 + 20 + 25 + 30 – 60 = 60 Days

360
II. No. of operating cycle = = 6 times
60

Operating cycle
III. Working Capital = Annual cash operating cost ×
360 Days
60 Days
= (`25,00,000 – `2,50,000) ×
360 Days
= `3,75,000

IV. Reduction in working capital = (`25,00,000 – `2,50,000) × 30 days/360 days

= `1,87,500
 TEST BOOK 21
TEST 5 – TREASURY AND CASH MANAGEMENT
Question 1

From the information and the assumption that the cash balance in hand on 1st January 2023 is `72,500
prepare a cash budget.

Assume that 50% of total sales are cash sales. Assets are to be acquired in the months of February
and April. Therefore, provisions should be made for the payment of `8,000 and `25,000 for the same. An
application has been made to the bank for the grant of a loan of `30,000 and it is hoped that the loan amount
will be received in the month of May.

It is anticipated that a dividend of `35,000 will be paid in June. Debtors are allowed one month’s
credit. Creditors for materials purchased and overheads grant one month’s credit. Sales commission at 3%
on sales is paid to the salesman each month.

Materials Salaries & Production Office & Selling

Months Sales
Purchases Wages Overheads OH
January 72,000 25,000 10,000 6,000 5,500
February 97,000 31,000 12,100 6,300 6,700
March 86,000 25,500 10,600 6,000 7,500
April 88,600 30,600 25,000 6,500 8,900
May 1,02,500 37,000 22,000 8,000 11,000
June 1,08,700 38,800 23,000 8,200 11,500
(10 Marks)

Question 2

The following information relates to Zeta Limited, a publishing company:

The selling price of a book is `15, and sales are made on credit through a book club and invoiced on
the last day of the month. Variable costs of production per book are materials (`5), labour (`4), and overhead
(`2). The sales manager has forecasted the following volumes:

Month No. of Books

November 1,000
December 1,000
January 1,000
February 1,250
March 1,500
April 2,000
May 1,900
June 2,200
July 2,200
August 2,300

Customers are expected to pay as follows:

One month after sale 40%

Two months after the sale 60%.

The company produces the books two months before they are sold and the creditors for materials
are paid two months after production. Variable overheads are paid in the month following production and
are expected to increase by 25% in April; 75% of wages are paid in the month of production and 25% in the
following month. A wage increase of 12.5% will take place on 1st March.
 TEST BOOK 22
The company is going through a restructuring and will sell one of its freehold properties in May for
`25,000, but it is also planning to buy a new printing press in May for `10,000. Depreciation is currently
`1,000 per month, and will rise to `1,500 after the purchase of the new machine.

The company’s corporation tax (of `10,000) is due for payment in March. The company presently has
a cash balance at bank on 31st December 2023, of `1,500.

You are required to prepare a cash budget for the six months from January to June, 2023.
(10 Marks)

Question 3

You are given below the Profit & Loss Accounts for two years for a company:

Particulars Year 1 Year 2 Particulars Year 1 Year 2

To Opening stock 32,00,000 40,00,000 By Sales 3,20,00,000 4,00,00,000
To Raw materials 1,20,00,000 1,60,00,000 By Closing stock 40,00,000 60,00,000
To Stores 38,40,000 48,00,000 By Misc. Income 4,00,000 4,00,000
To Manufacturing exps 51,20,000 64,00,000
To Other expenses 40,00,000 40,00,000
To Depreciation 40,00,000 40,00,000
To Net Profit 42,40,000 72,00,000
3,64,00,000 4,64,00,000 3,64,00,000 4,64,00,000

Sales are expected to be `4,80,00,000 in year 3.

As a result, other expenses will increase by `20,00,000 besides other charges. Only raw materials are
in stock. Assume sales and purchases are in cash terms and the closing stock is expected to go up by the same
amount as between year 1 and 2. You may assume that no dividend is being paid. The Company can use 75%
of the cash generated to service a loan.

Compute how much cash from operations will be available in year 3 for the purpose? Ignore income
tax.
(10 Marks)

Question 4

Tarus Ltd. has an estimated cash payments of `8,00,000 for a one month period and the payments are
expected to steady over the period. The fixed cost per transaction is `250 and the interest rate on
marketable securities is 12% p.a.

Calculate the optimal transaction size, average cash and number of transactions during one month.
(5 Marks)
 TEST BOOK 23
SOLUTION TEST 5
Solution 1
Monthly Cash Budget for Six Months, January to June 2023
Particulars Jan Feb March April May June Total
Opening balance 72,500 96,340 1,21,330 1,55,650 1,51,292 2,05,767 72,500
Receipts:
Cash sales 36,000 48,500 43,000 44,300 51,250 54,350 2,77,400
Collection from debtors - 36,000 48,500 43,000 44,300 51,250 2,23,050
Bank Loan - - - - 30,000 - 30,000
Cash available (A) 1,08,500 1,80,840 2,12,830 2,42,950 2,76,842 3,11,367 6,02,950
Payments:
Payment for purchases - 25,000 31,000 25,500 30,600 37,000 1,49,100
Salaries and wages 10,000 12,100 10,600 25,000 22,000 23,000 1,02,700
Production OH - 6,000 6,300 6,000 6,500 8,000 32,800
Selling and Office OH - 5,500 6,700 7,500 8,900 11,000 39,600
Sales commission 2,160 2,910 2,580 2,658 3,075 3,261 16,644
Purchase of Assets - 8,000 - 25,000 - - 33,000
Dividend paid - - - - - 35,000 35,000
Total payments (B) 12,160 59,510 57,180 91,658 71,075 1,17,261 4,08,844
Closing balance (A - B) 96,340 1,21,330 1,55,650 1,51,292 2,05,767 1,94,106 1,94,106

Solution 2
Monthly Cash Budget for Six Months, January to June 2023
Particulars Jan Feb March April May June
Opening balance 1,500 3,250 1,500 (11,912) (15,024) 576
Receipts:
Sales receipts 15,000 15,000 16,500 20,250 25,500 29,400
Sell of property - - - - 25,000 -
Cash available (A) 16,500 18,250 18,000 8,338 35,476 29,976
Payments:
Payment for purchases 5,000 6,250 7,500 10,000 9,500 11,000
Variable overheads 2,500 3,000 4,000 3,800 5,500 5,500
Wages 5,750 7,500 8,412 9,562 9,900 10,237
Printing press - - - - 10,000 -
Corporation tax - - 10,000 - - -
Total payments (B) 13,250 16,750 29,912 23,362 34,900 26,737
Closing balance (A - B) 3,250 1,500 (11,912) (15,024) 576 3,239

Working note:
Calculation of Sales receipts, payment for Purchases, Variable overheads and Wages:
Particulars Nov Dec Jan Feb March April May June
Forecast sales in units 1,000 1,000 1,000 1,250 1,500 2,000 1,900 2,200
(no. of books)

1. Sales receipts:
Sales @ `15/unit 15,000 15,000 15,000 18,750 22,500 30,000 28,500 33,000
1 month 40% - 6,000 6,000 6,000 7,500 9,000 12,000 11,400
2 months 60% - - 9,000 9,000 9,000 11,250 13,500 18,000
- - 15,000 15,000 16,500 20,250 25,500 29,400
2. Pay for purchase:
Quantity produced 1,000 1,250 1,500 2,000 1,900 2,200 2,200 2,300
(2 months before sales)
Materials cost @ `5 p.u. 5,000 6,250 7,500 10,000 9,500 11,000 11,000 11,500
Payment after 2 month - - 5,000 6,250 7,500 10,000 9,500 11,000
 TEST BOOK 24
3. Pay for variable oh:
Quantity produced 1,000 1,250 1,500 2,000 1,900 2,200 2,200 2,300
Variable oh @ `2 and 2,000 2,500 3,000 4,000 3,800 5,500 5,500 5,750
`2.50 p.u. from April
Payment next month - 2,000 2,500 3,000 4,000 3,800 5,500 5,500

4. Pay for wages:

Quantity produced 1,000 1,250 1,500 2,000 1,900 2,200 2,200 2,300
Wages @ `4 and `4.50 4,000 5,000 6,000 8,000 8,550 9,900 9,900 10,350
p.u. from March
Same month 75% 3,000 3,750 4,500 6,000 6,412 7,425 7,425 7,762
Next month 25% - 1,000 1,250 1,500 2,000 2,137 2,475 2,475
- 4,750 5,750 7,500 8,412 9,562 9,900 10,237

Solution 3
Projected Profit and Loss Account for the year 3
(` in Lakhs)
Year 2 Year 3 Year 2 Year 3
Particulars Particulars
(Actual) (Projected) (Actual) (Projected)
To Raw Materials Consumed 140 168 By Sales 400 480
To Stores 48 57.60 By Misc. Income 4 4
To Manufacturing Expenses 64 76.80
To Other Expenses 40 60
To Depreciation 40 40
To Net Profit 72 81.60
404 484 404 484

Cash Flow:
Particulars (` in Lakhs)
Net Profit 81.60
Add: Depreciation 40
121.60
Less: Cash required for increase in stock (20 Lakhs same as between year 1 and 2) (20)
Net Cash Inflow 101.60

Available for servicing the loan: 75% of `1,01,60,000 = `76,20,000

Working Notes:

(a) Material consumed in year 2 = `140 Lakhs ÷ `400 lakhs = 35% of sales

Likely consumption in year 3 = `480 Lakhs × 35% = `168 Lakhs

(b) Stores are 12% of sales, as in year 2

(c) Manufacturing expenses are 16% of sales

Solution 4

2 × 8 ,00 ,000 × 12 × 250

Optimal transaction size = = `2,00,000
0.12

Number of transactions p.m. = Monthly cash requirement ÷ Transaction size

= `8,00,000 ÷ `2,00,000 = 4 transactions
 TEST BOOK 25
TEST 6 – RATIO ANALYSIS
Question 1

Complete the following annual financial statements on the basis of ratios given below:

Profit and loss account for the year ended 31st March, 2023
Particulars ` Particulars `
To Cost of goods sold 6,00,000 By Sales 20,00,000
To Operating expenses -
To EBIT -
20,00,000 20,00,000
To Debenture interest 10,000 By EBIT -
To Income tax -
To Net profit -
- -

Balance Sheet as at 31st March, 2023

Liabilities ` Assets `
Net worth: Fixed assets -
Share capital - Current assets:
Reserve and surplus - Cash -
10% Debenture - Stock -
Sundry creditors 60,000 Debtors 35,000
- -

Net Profit to sales 5% Current Ratio 1.5 times

Return on net worth 20% Share capital to reserves 4:1
Rate of Income - tax 50% Inventory turnover 15 times
(based on cost of goods sold)

(10 Marks)

Question 2

Manan Pvt. Ltd. gives you the following information relating to the year ending 31st March, 2023:

Current Ratio : 2.5 : 1

Debt-Equity Ratio : 1 : 1.5
Return on Total Assets (After Tax) : 15%
Total Assets Turnover Ratio : 2
Gross Profit Ratio : 20%
Stock Turnover Ratio : 7
Net Working Capital : `13,50,000
Fixed Assets : `30,00,000
1,80,000 Equity Shares of : `10 each
60,000, 9% Preference Shares of : `10 each
Opening Stock : `11,40,000

You are required to calculate:

(a) Quick Ratio

(b) Fixed Assets Turnover Ratio
(c) Proprietary Ratio
(d) Earnings per Share
(10 Marks)
 TEST BOOK 26
Question 3

The Balance Sheets of A Ltd. and B Ltd. as on 31st March 2023 are as follows:

Particulars A Ltd B Ltd

Liabilities:
Share Capital 40,00,000 40,00,000
Reserve and surplus 32,30,000 25,00,000
Secured Loans 25,25,000 32,50,000
Current Liabilities and provisions:
Sundry Creditors 15,00,000 14,00,000
Outstanding Expenses 2,00,000 3,00,000
Provision for Tax 3,00,000 3,00,000
Proposed Dividend 6,00,000 -
Unclaimed Dividend 15,000 -
Assets: 1,23,70,000 1,17,50,000
Fixed Assets (Net) 80,00,000 50,00,000
Investments 15,00,000 -
Inventory at Cost 23,00,000 45,00,000
Sundry Debtors - 17,00,000
Cash & Bank 5,70,000 5,50,000
1,23,70,000 1,17,50,000

Additional information available:

(i) 75% of the Inventory in A Ltd. readily saleable at cost plus 20%,
(ii) 50% of Sundry Debtors of B Ltd. are due from C Ltd. which is not in a position to repay the amount B
Ltd. agreed to accept 15% debentures of C Ltd.
(iii) B Ltd. had also proposed 15% dividend but that was not shown in the accounts.
(iv) At the year end, B Ltd. sold investments amounting to `1,20,000 and repaid Sundry Creditors.

On the basis of the given Balance Sheet and the additional information, you are required to evaluate
liquidity of the companies. All working should form part of the answer.
(10 Marks)

Question 4

X Co. has made plans for the next year. It is estimated that the company will employ total assets of `8,00,000;
50 per cent of the assets being financed by borrowed capital at an interest cost of 8 per cent per year. The
direct costs for the year are estimated at `4,80,000 and all other operating expenses are estimated at `80,000.
The goods will be sold to customers at 150 per cent of the direct costs. Tax rate is assumed to be 50 per cent.

You are required to calculate: (a) Operating profit margin (before tax), (b) Net profit margin (after tax);
(c) Return on assets (on operating profit after tax); (d) Asset turnover and (e) Return on owners’ equity.

(5 Marks)
 TEST BOOK 27
SOLUTION TEST 6
Solution 1
Profit and loss account for the year ended 31st March, 2023

Particulars ` Particulars `
To Cost of goods sold 6,00,000 By Sales 20,00,000
To Operating expenses 11,90,000
To EBIT 2,10,000
20,00,000 20,00,000
To Debenture interest 10,000 By EBIT 2,10,000
To Income tax 1,00,000
To Net profit 1,00,000
2,10,000 2,10,000

Balance Sheet as at 31st March, 2023

Liabilities ` Assets `
Net worth: Fixed assets 5,70,000
Share capital 4,00,000 Current assets:
Reserve and surplus 1,00,000 Cash 15,000
10% Debenture 1,00,000 Stock 40,000
Sundry creditors 60,000 Debtors 35,000
6,60,000 6,60,000

Solution 2

(a) Calculation of Quick Ratio

Quick Assets 9,90,000

Quick Ratio = Current Liabities
= 9,00,000
= 1.1 : 1

(b) Calculation of Fixed Assets Turnover Ratio

Sales 1,05,00,000
Fixed Assets Turnover Ratio = Fixed Assets
= 30,00,000
= 3.5

(c) Calculation of Proprietary Ratio

Proprietary Fund 28,50,000

Proprietary Ratio = Total Assets
= 52,50,000
= 0.54

(d) Calculation of Earnings per Equity Share (EPS)

PAT − Preference Share Dividend

Earnings per Equity Share (EPS) = Number of Equity Shares
7,87,500 −9% of 6,00,000
= 1,80,000
= `4.075

Workings Notes:
Current Assets
(i) Current Ratio = Current Liabilities
= 2.5
Current Assets = 2.5 Current Liabilities

Working Capital = Current Assets – Current Liabilities

13,50,000 = 2.5 Current Liabilities – Current Liabilities
Current Liabilities = 13,50,000 ÷ 1.5 = 9,00,000

Current Assets = 2.5 Current Liabilities

 TEST BOOK 28
= 2.5 × 9,00,000 = 22,50,000

(ii) Sales = Total Assets Turnover × Total Assets

= 2 × (Fixed Assets + Current Assets)
2 × (30,00,000 + 22,50,000) = 1,05,00,000
(iii) Cost of Goods Sold = 80% of Sales
= 80% of 1,05,00,000 = 84,00,000

Cost of Goods Sold 84,00,000

(iv) Average Stock = Stock Turnover Ratio
= 7
= 12,00,000

Closing Stock = (Average Stock × 2) – Opening Stock

= (12,00,000 × 2) – 11,40,000 = 12,60,000

Quick Assets = Current Assets – Closing Stock

= 22,50,000 – 12,60,000 = 9,90,000

Debt
Debt – Equity Ratio = = 1 : 1.5
Equity
1.5 Debt = Equity

Total Assets = Equity + Preference Share Capital + Debt + CL

52,50,000 = 1.5 Debt + 6,00,000 + 1.5 Debt + 9,00,000 = 2.5 Debt
Debt = 37,50,000 ÷ 2.5 = 15,00,000

Equity = 15,00,000 × 1.5 = 22,50,000

Proprietary Fund = Equity + Preference Share Capital
= 22,50,000 + 6,00,000 = 28,50,000

(v) Profit After Tax (PAT) = Total Assets × Return on Total Assets
= 52,50,000 × 15% = 7,87,500

Solution 3

Particulars A B
Current Assets and Liquid Assets:
Stock (23,00,000 × 75%) + 20% 20,70,000 -
Debtor (17,00,000 × 50%) - 8,50,000
Cash & Bank 5,70,000 5,50,000
Liquid Assets 26,40,000 14,00,000
Add: Stock (23,00,000 × 25%) 5,75,000 45,00,000
Total Current Assets 32,15,000 59,00,000
Current Liabilities:
Proposed Dividend 6,00,000 6,00,000
Creditor 15,00,000 15,20,000
Out Expenses 2,00,000 3,00,000
Provision for tax 3,00,000 3,00,000
Unclaimed Dividend 15,000 -
26,15,000 27,20,000
Evaluation of Liquidity
RATIO A B
CA 32 ,15 ,000 59 ,00 ,000
1. Current Ratio  = 1.23 = 2.17
CL 26 ,15 ,000 27 ,20 ,000
LA 26 ,40 ,000 14 ,00 ,000
2. Liquid Ratio  = 1.009 = .51
CL 26 ,15 ,000 27 ,20 ,000
 TEST BOOK 29
Solution 4

EBIT 1 ,60 ,000

(a) Operating Profit Margin = × 100 = × 100 = 22.22%
Sales 7 ,20 ,000

EAT 64 ,000
(b) Net Profit Margin = × 100 = × 100 = 8.89%
Sales 7 ,20 ,000

EBIT (1−t) 1,60,000 (1−.50)

(c) Return on Assets = Assets
= 8,00,000
= 10%

Sales 7 ,20 ,000

(d) Assets turnover = = = 0.9 times
Total Assets 8 ,00 ,000

EAT 64 ,000
(e) Return on Equity = × 100 = × 100 = 16%
Equity Fund 4 ,00 ,000

The Net Profit is calculated as follows:

Particulars `
Sales Revenue (150% of `4,80,000) 7,20,000
Less: Direct Cost 4,80,000
Gross Profit 2,40,000
Less: Other operating expenses 80,000
Operating Profit/EBIT 1,60,000
Less: Interest on 8% Debt (8,00,000 × 50% × 8%) 32,000
EBT 1,28,000
Less: Taxes @ 50% 64,000
EAT 64,000
 TEST BOOK 30
TEST 7 – INVESTMENT DECISIONS OR CAPITAL BUDGETING
Question 1

XYZ Ltd is planning to introduce a new product with a projected life of 8 years. The project to be set up in a
backward region, qualifies for a one time (as its starting) tax free subsidy from the government of `20,00,000
equipment cost will be `140 lakhs and additional equipment costing `10,00,000 will be needed at the
beginning of the third year. At the end of 8 years the original equipment will have no resale value but the
supplementary equipment can be sold for `1,00,000. A working capital of `15,00,000 will be needed. The sales
volume over the eight years period has been forecasted as follows:

Year Units
1 80,000
2 1,20,000
3-5 3,00,000
6-8 2,00,000

A sale price of `100 per unit is expected and variable expenses will amount to 40% of sales revenue.
Fixed cash operating costs will amount to `16,00,000 per year. In addition an extensive advertising campaign
will be implemented requiring annual outlays as follows:

Year (` in lakhs)
1 30
2 15
3-5 10
6-8 4

The company is subject to 50% tax rate and considers 12% to be an appropriate after tax cost of capital
for this project. The company follows the straight line method of depreciation.

Should the project be accepted?

(10 Marks)

Question 2

Total fund available is `3,00,000. Determine the optimal combination of projects assuming that the projects
are (a) Divisible or (b) Indivisible.

Project Name Initial Investment NPV

P `1,00,000 `20,000
Q `3,00,000 `35,000
R `50,000 `16,000
S `2,00,000 `25,000
T `1,00,000 `30,000
(10 Marks)

Question 3

MNP Limited is thinking of replacing its existing machine by a new machine which would cost `60 lakhs. The
company’s current production is `80,000 units, and is expected to increase to 1,00,000 units, if the new
machine is bought. The selling price of the product would remain unchanged at `200 per unit. The following
is the cost of producing one unit of product using both the existing and new machine:

Existing Machine New Machine

Particulars Difference
(80,000 units) (1,00,000 units)
Materials 75.00 63.75 (11.25)
Wages and Salaries 51.25 37.50 (13.75)
 TEST BOOK 31
Supervision 20.00 25.00 5.00
Repairs and Maintenance 11.25 7.50 (3.75)
Power and Fuel 15.50 14.25 (1.25)
Depreciation 0.25 5.00 4.75
Allocated Corporate Overheads 10.00 12.50 2.50
Total 183.25 165.50 (17.75)

The existing machine has an accounting book value of `1,00,000, and it has been fully depreciated for
tax purpose. It is estimated that machine will be useful for 5 years. The supplier of the new machine has offered
to accept the old machine for `2,50,000. However, the market price of old machine today is `1,50,000 and it is
expected to be `35,000 after 5 years. The new machine has a life of 5 years and a salvage value of `2,50,000 at
the end of its economic life.

Assume corporate Income tax rate at 40%, and depreciation is charged on straight line basis for
Income-tax purposes. Further assume that book profit is treated as ordinary income for tax purpose. The
opportunity cost of capital of the Company is 15%.

Required:

(i) Estimate net present value of the replacement decision.

(ii) Estimate the internal rate of return of the replacement decision.
(iii) Should Company go ahead with the replacement decision? Suggest.

Year (t) 1 2 3 4 5
PVIF0.15,t 0.8696 0.7561 0.6575 0.5718 0.4972
PVIF0.20,t 0.8333 0.6944 0.5787 0.4823 0.4019
PVIF0.25,t 0.8000 0.6400 0.5120 0.4096 0.3277
PVIF0.30,t 0.7692 0.5917 0.4552 0.3501 0.2693
PVIF0.35,t 0.7407 0.5487 0.4064 0.3011 0.2230

(10 Marks)

Question 4

ANP Ltd. Is providing the following information:

Annual cost of saving `96,000

Useful life 5 years
Salvage value zero
Internal rate of return 15%
Profitability index 1.05

Table of discount factor:

Discount Years
Factor 1 2 3 4 5 Total
15% 0.870 0.756 0.658 0.572 0.497 3.353
14% 0.877 0.769 0.675 0.592 0.519 3.432
13% 0.886 0.783 0.693 0.614 0.544 3.52

You are required to calculate:

(a) Cost of the project
(b) Payback period
(c) Net present value of cash inflow
(d) Cost of capital
(10 Marks)
 TEST BOOK 32
SOLUTION TEST 7
Solution 1
Net Present Value

Year Particulars ` DF @ 12% PV

0 Initial outflows (1,35,00,000) 1.000 (1,35,00,000)
(140 – 20 + 15) Lakhs
1 CFAT 2,00,000 0.893 1,78,600
2 CFAT less Additional Equipment 24,50,000 0.797 19,52,650
(34,50,000 – 10,00,000)
3-5 CFAT 85,25,000 1.915 1,63,25,375
6–8 CFAT 58,25,000 1.363 79,39,475
8 Working Capital and Salvage 16,00,000 0.404 6,46,400
(15,00,000 + 1,00,000)
NPV 1,35,42,500

Company should accept the proposal having positive NPV of the project.

Working Notes:
1. Statement of CFAT
Particulars 1 2 3–5 6–8
Units sold 80,000 1,20,000 3,00,000 2,00,000
Sales @ `100 p.u. 80,00,000 1,20,00,000 3,00,00,000 2,00,00,000
Less: VC @ 40% 32,00,000 48,00,000 1,20,00,000 80,00,000
Contribution 48,00,000 72,00,000 1,80,00,000 1,20,00,000
Less: Advertisement expenses (30,00,000) (15,00,000) (10,00,000) (4,00,000)
Less: Cash fixed cost (16,00,000) (16,00,000) (16,00,000) (16,00,000)
Less: Depreciation (15,00,000) (15,00,000) (16,50,000) (16,50,000)
PBT (13,00,000) 26,00,000 1,37,50,000 83,50,000
Less: Tax @ 50% - (6,50,000) (68,75,000) (41,75,000)
PAT (13,00,000) 19,50,000 68,75,000 41,75,000
Add: Depreciation 15,00,000 15,00,000 16,50,000 16,50,000
CFAT 2,00,000 34,50,000 85,25,000 58,25,000

2. Depreciation:
Original Cost  Subsidy  Salvage 1 ,20 ,00 ,000
Main equipment (t0 - t8) = =
Life of Equipment 8 Years
= 15,00,000

Original Cost  Salvage 9 ,00 ,000

Additional equipment (t3 - t8) = =
Life of Equipment 6 Years
= 1,50,000

3. Tax for year 2 = 50% of (26,00,000 – 13,00,000) = 6,50,000

Note: As per section 32 of Income Tax Act “Depreciation is not allowed on subsidized part of asset”

Solution 2
(a) Statement of Rank and Selection of Projects
(Divisible Situation)
Projects PI (1+ NPV/Investment) Rank Project Cost Project (%) Investment
P 1 + 20,000/1,00,000 = 1.20 3 `1,00,000 100% `1,00,000
Q 1 + 35,000/3,00,000 = 1.11 5 `3,00,000 - -
R 1 + 16,000/50,000 = 1.32 1 `50,000 100% `50,000
 TEST BOOK 33
S 1 + 25,000/2,00,000 = 1.13 4 `2,00,000 25% `50,000 (b.f.)
T 1 + 30,000/1,00,000 = 1.30 2 `1,00,000 100% `1,00,000
Total Investment `3,00,000

Optimum investment: 100% of P, R, T and ¼ of S.

(b) Statement of Rank and Selection of Projects

(Indivisible Situation)
Possible Combinations Combined Investment Combined NPV
P+R+T `2,50,000 `66,000
P+S `3,00,000 `45,000
Q `3,00,000 `35,000
R+S `2,50,000 `41,000
S+T `3,00,000 `55,000

Invest in combination of P, R and T having highest combined NPV and invest remaining `50,000 elsewhere.

Solution 3
(i) Statement of NPV
Year Particulars ` DF @ 15% PV
0 Initial outflows (58,50,000) 1.0000 (58,50,000)
1-5 Cash Flow After Tax 22,84,000 3.3522 76,56,425
5 Net Salvage 2,50,000 – 35,000 (1 – 0.40) 2,29,000 0.4972 1,13,859
NPV 19,20,284

Working Notes:

1. Calculation of initial outflow:

Cost of new machine `60,00,000
Less: Exchange value of old machine (`2,50,000)
Add: Tax payment on profit on exchange of old machine `1,00,000
(2,50,000 – Nil) × 40%
Initial outflow `58,50,000

2. Calculation of incremental CFAT:

Increase in sales (200 × 20,000 units) `40,00,000
Less: Increase in operating cost (1,00,000 × 148) – (80,000 × 173) `9,60,000
(excluding Depreciation and Allocated overheads)
Less: Increase in depreciation [(60,00,00 – 2,50,000) ÷ 5] – Nil `11,50,000
Profit before tax `18,90,000
Less: Tax @ 40% `7,56,000
Profit after tax `11,34,000
Add: Depreciation `11,50,000
Incremental CFAT `22,84,000

3. Calculation of Incremental Salvage:

Salvage of new machine (Salvage = WDV; no gain or loss) `2,50,000
Less: Salvage of old machine (Salvage > WDV) `35,000
Tax on gain 40% of 35,000 (35,000 - Nil) `14,000 `21,000
Incremental Salvage `2,29,000

Notes:
(a) The old machine could be sold for `1,50,000 in the market. Since exchange value is more than the market
value, company will exchange it at `2,50,000.
(b) Old machine has fully depreciated for tax purpose, therefore depreciation of old machine as well as WDV
are NIL.
 TEST BOOK 34
(c) Allocated overheads are allocations from corporate office therefore they are irrelevant for computation
of CFAT.

(ii) Calculation of IRR:

Since NPV computed in Part (i) is positive. Let us discount cash flows at higher rate say at 25% or 30%

Statement of NPV
Year Particulars ` DF @ 25% PV DF @ 30% PV
0 Initial outflows (58,50,000) 1.0000 (58,50,000) 1.0000 (58,50,000)
1-5 Cash Flow After Tax 22,84,000 2.6893 61,42,361 2.4355 55,62,682
5 Incremental Salvage 2,29,000 0.3277 75,043 0.2693 61,670
NPV 3,67,404 -2,25,648

3,67 ,404
IRR = 25% +  5% = 28.10%
3,67 ,404  2,25 ,648

(iii) Advise: The company should go ahead with replacement project, since it has positive NPV.

Solution 4

(a) Cost of the project:

At IRR,
Present value of inflows = Present value of outflows
Present value of outflows = Annual cost of saving × Cumulative discount factor
@ IRR for 5 years
= `96,000 × 3.353
Cost of project = `3,21,888

(b) Payback Period:

Initial Outflow
Payback period =
Equal Annual Cash Inflows / Saving
3,21 ,888
= = 3.353 years
96 ,000

(c) Net Present Value of cash inflows:

PV of Inflows
PI =
PV of Outflows
PV of Inflows
1.05 =
3,21 ,888

PV of Inflows = 3,21,888 × 1.05 = `3,37,982.4

NPV = PV of inflows – PV of outflows

= `3,37,982.40 – `3,21,888 = `16,094.40

(d) Cost of Capital:

Pr esent Value of Inflows
Cum DF @ cost of capital for 5 years =
Annual Inflows
3 ,37 ,982 .40
= = 3.52065
96 ,000

Cost of capital = 13% (Given in table)

 TEST BOOK 35
TEST 8 – COST OF CAPITAL
Question 1

The following is the capital structure of Simons Company Ltd. as on 31.12.1998:

Equity shares (10,000 shares of `100 each) `10,00,000

10% Preference shares of `100 each `4,00,000
12% Debentures `6,00,000
`20,00,000

The market price of the company’s share is `110 and it is expected that a dividend of `10 per share
would be declared for the year 1998. The dividend growth rate is 6%.

(i) If the company is in the 50% tax bracket, compute the WACC.
(ii) Assuming that in order to finance an expansion plan, the company intends to borrow a fund of
`10,00,000 bearing 14% rate of interest, What will be the company’s revised weighted average cost of
Capital? This financing decision is expected to increase dividends from `10 to `12 per share. However,
the market price of equity share is expected to decline from `110 to `105 per share.
(10 Marks)

Question 2

The R & G Company has following capital structure at 31st March, 2004, which is considered to be optimum:

13% debenture `3,60,000

11% preference share capital `1,20,000
Equity share capital (2,00,000 shares) `19,20,000
The company's share has a current market price of `27.75 per share. The expected dividend per share
in next year is 50 percent of the 2004 EPS. The EPS of last 10 years is as follows. The past trends are expected
to continue:

Year 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
EPS (`) 1.00 1.120 1.254 1.405 1.574 1.762 1.974 2.211 2.476 2.773
The company can issue 14 percent new debenture. The company's debenture is currently selling at
`98. The new preference issue can be sold at a net price of `9.80, paying a dividend of `1.20 per share. The
company's marginal tax rate is 50%.

(i) Calculate the after tax cost (a) of a new debts and new preference share capital, (b) of ordinary equity,
assuming new equity comes from retained earnings.
(ii) Calculate the marginal cost of capital.
(iii) How much can be spent for capital investment before new ordinary share must be sold? Assuming that
retained earning available for next year's investment are 50% of 2004 earnings.
(iv) What will be marginal cost of capital [cost of fund raised in excess of the amount calculated in part (iii)]
if the company can sell new ordinary shares to net `20 per share? The cost of debt and of preference
capital is constant.
(10 Marks)

Question 3

ABC Ltd. wishes to raise additional finance of `20 lakhs for meeting its investment purpose. The company has
`4,00,000 in the form of retained earnings available for investment purposes. The following are the further
details:

Debt equity ratio : 25 : 75

Cost of debt:
Upto `2,00,000 : 10% (before tax) and
 TEST BOOK 36
Beyond `2,00,000 : 13% (before tax)
Earning per share : `12 per share
Dividend payout : 50% of earnings
Expected growth rate : 10%
Current market price : `60 per share
Company’s tax rate : 30%
Shareholder’s personal tax rate : 20%.

Required:

(i) Calculate the post tax average cost of additional debt.

(ii) Calculate the cost of retained earnings and cost of equity.
(iii) Calculate the overall weighted average (after tax) cost of additional finance.
(10 Marks)

Question 4

A company issues:
 15% convertible debentures of `100 each at par with a maturity period of 6 years. On maturity, each
debenture will be converted into 2 equity shares of the company. The risk-free rate of return is 10%,
market risk premium is 18% and beta of the company is 1.25. The company has paid dividend of `12.76
per share. Five year ago, it paid dividend of `10 per share. Flotation cost is 5% of issue amount.

 5% preference shares of `100 each at premium of 10%. These shares are redeemable after 10 years at
par. Flotation cost is 6% of issue amount.

Assuming corporate tax rate is 40%.

(a) Calculate the cost of convertible debentures using the approximation method.
(b) Use YTM method to calculate cost of preference shares.

Year 1 2 3 4 5 6 7 8 9 10
PVIF0.03,t 0.971 0.943 0.915 0.888 0.863 0.837 0.813 0.789 0.766 0.744
PVIF 0.05,t 0.952 0.907 0.864 0.823 0.784 0.746 0.711 0.677 0.645 0.614
PVIFA0.03,t 0.971 1.913 2.829 3.717 4.580 5.417 6.230 7.020 7.786 8.530
PVIFA0.05,t 0.952 1.859 2.723 3.546 4.329 5.076 5.786 6.463 7.108 7.722

Interest rate 1% 2% 3% 4% 5% 6% 7% 8% 9%
FVIFi,5 1.051 1.104 1.159 1.217 1.276 1.338 1.403 1.469 1.539
FVIFi,6 1.062 1.126 1.194 1.265 1.340 1.419 1.501 1.587 1.677
FVIFi,7 1.072 1.149 1.230 1.316 1.407 1.504 1.606 1.714 1.828

(10 Marks)
 TEST BOOK 37
SOLUTION TEST 8
Solution 1

(i) Calculation of Weighted Average Cost of Capital

WACC (Ko) = KeWe + KpWp + KdWd

= 15.09% × 10 + 10% × 4 + 6% × 6 = 11.35%
20 20 20

D1 10
Ke = +g = + .06 = 15.09%
P0 110

Kp = Rate of preferential dividend [FV = NP] = 10%

Kd = I (1 - t) = 12% (1 – 0.50) = 6%

(ii) Calculation of Revised WACC

Revised WACC (Ko) = KeWe + KpWp + KdWd + KTLWTL

= 17.43% × 10 + 10% × 4 + 6% × 6 + 7% × 10 = 10.68%
30 30 30 30

D1 12
Revised Ke = +g = + .06 = 17.43%
P0 105

KTL = I (1 - t) = 14% (1 – 0.50) = 7%

Solution 2

Assumption: The present capital structure is optimum. Hence, it will be followed in future.

Existing Capital Structure Analysis

Name of source Amount (`) Proportion

13% debentures 3,60,000 0.15
11% Preference 1,20,000 0.05
Equity share capital 19,20,000 0.80
Total 24,00,000 1.00

(i) (a) After tax cost of new debt

I(1  t ) 14 (1  .50)
Kd = × 100 = × 100 = 7.143%
NP 98

After tax cost of new preference shares

PD 1.20
Kp = × 100 = × 100 = 12.25%
NP 9.80

(b) Cost of new equity (comes from retained earnings)

D1 1.3865
Ke = +g = + 0.12 = 17%
P0 (old ) 27.75
 TEST BOOK 38

(ii) MCC (Ko) = KdWd + KpWp + KeWe

= 7.143% × .15 + 12.245% × .05 + 17% × .80 = 15.28%

(iii) The company can pay the following amount without selling the new shares:

Equity (retained earnings in this case) = 80% of the total capital

2 ,77 ,300
Therefore, investment before new issue = = `3,46,625
80 %

Retained earnings = `1.3865 × 2,00,000 = `2,77,300

(iv) MCC (Ko)

= KdWd + KpWp + KeWe
= 7.143% × .15 + 12.245% × .05 + 18.93% × .80 = 16.83%

If the company pay more than `3,46,625, it will have to issue new shares. The cost of new issue of
ordinary share is:
D1 1.3865
Ke = +g = + 0.12 = 18.93%
P0 ( new ) 20

Solution 3

Total capital required is `20 lakhs. With a debt-equity ratio of 1:3. It means `5 lakhs is to be raised through
debt and `15 lakhs through equity. Out of `15 lakhs, `4 lakhs are available in the form of retained earnings
hence `11 lakhs will have to raise by issuing equity shares.

(i) Post tax average cost of additional debt:

Kd1 = I (1 - t) = 10% (1 – 0.30) = 7%

Kd2 = I (1 - t) = 13% (1 – 0.30) = 9.10%

Average Kd = Kd1Wd1 + Kd2Wd2 = 7% × 2 + 9.10% × 3 = 8.26%

5 5

(ii) Cost of retained earning & cost of equity:

D1 6  10 %
Ke = +g = + 0.10 = 21%
P0 60

Kr = Ke (1-PT) = 21% (1 - .20) = 16.80%

D0 = `12 × 50% = `6

(iii) Overall cost of additional finance:

Ko = KeWe + KrWr + KdWd

= 21% × 11 + 16.80% × 4 + 8.26% × 5 = 16.98%
20 20 20

Assumption: DPS is treated at Do.

Solution 4

(a) Calculation of cost of Convertible Debentures using Approximation method:

 TEST BOOK 39
RV−NP 130.58−95
I (1 − t) + 15 (1 − 0.40) +
Kd = RV+NP
n
× 100 = 130.58+95
6
× 100
2 2
= 13.24%

Working Notes:

Determination of Redemption value:

Higher of
(i) The cash value of debentures = `100

(ii) Value of equity shares = 2 shares × `48.72 (1 + 0.05)6 = `130.58

`130 will be taken as redemption value as it is higher than the cash option and attractive to the investors.

Calculation of Value of Share today:

D1 12.76 (1+0.05)
P0 = Ke −g
= 32.50%−5%
= `48.72

Ke = Rf + β (Rm - Rf) = 10% + 1.25 × 18% = 32.50%

5 12.76
g = √ = 5% or
10.00

g = 12.76 ÷ 10.00 = 1.276 (5% for 5 year; given in interest rate table)

(b) Calculation of Cost of Preference shares using YTM method::

Calculation of NPV at two discount rates:

Present Value Present Value

Year Cash Flow
3% DCF 5% DCF
0 103.40 1.000 (103.40) 1.000 (103.40)
1 - 10 5 8.530 42.65 7.722 38.61
10 100 0.744 74.40 0.614 61.40
NPV +13.65 -3.39

NPVL 13 .65
IRR/Kd = LR + × (H - L) = 3% + × (5% - 3%)
NPVL  NPVH 13 .65  (  3.39 )
= 4.60%

Working Note:

Net Proceeds = Issue Price – Flotation Cost

= (100 + 10% Premium) – 6% = `103.40
 TEST BOOK 40
TEST 9 – CAPITAL STRUCTURE
Question 1

X Ltd. and Y Ltd. are identical except that the former uses debt while the latter does not. Thus levered firm has
issued 10% Debentures of `9,00,000. Both the firms earn EBIT of 20% on total assets of `15,00,000. Assuming
tax rate is 50% and capitalization rate is 15% for an all equity firm.

(i) Compute the value of the two firms using NI approach.

(ii) Compute the value of the two firms using NOI approach.
(iii) Calculate the overall cost of capital, Ko for both the firms using NOI approach.
(10 Marks)

Question 2

Alpha Limited and Beta Limited are identical except for capital structures. Alpha Ltd. has 50 per cent debt and
50 per cent equity, whereas Beta Ltd. has 20 per cent debt and 80 per cent equity. (All percentages are in
market value terms). The borrowing rate for both companies is 8 per cent in a no-tax world, and capital
markets are assumed to be perfect.

(a) (i) If you own 2 per cent of the shares of Alpha Ltd., determine your return if the company has net
operating income of `3,60,000 and the overall capitalisation rate of the company, Ko is 18 per cent?

(ii) Calculate the implied required rate of return on equity?

(b) Beta Ltd. has the same net operating income as Alpha Ltd. (i) Determine the implied required equity
return of Beta Ltd.? (ii) Analyse why does it differ from that of Alpha Ltd.?
(10 Marks)

Question 3

RST Ltd. is expecting an EBIT of `4,00,000 for F.Y. 2015-16. Presently the company is financed by equity share
capital `20,00,000 with equity capitalization rate of 16%. The company is contemplating to redeem part of the
capital by introducing debt financing. The company has two options to raise debt to the extent of 30% or 50%
of the total fund. It is expected that for debt financing upto 30%, the rate of interest will be 10% and equity
capitalization rate will increase to 17%. If the company opts for 50% debt, then the interest rate will be 12%
and equity capitalization rate will be 20%.

You are required to compute value of the company; its overall cost of capital under different options
and also state which is the best option.
(10 Marks)

Question 4

The following data relate to two companies belonging to the same risk class:

A Ltd. B Ltd.
Expected Net operating Income `18,00,000 `18,00,000
12% Debt `54,00,000 -
Equity Capitalization Rate - 18

Required:
(a) Determine the total market value, Equity capitalization rate and weighted average cost of capital for
each company assuming no taxes as per M.M. Approach.
(b) Determine the total market value, Equity capitalization rate and weighted average cost of capital for
each company assuming 40% taxes as per M.M. Approach.
(10 Marks)
 TEST BOOK 41
SOLUTION TEST 9
Solution 1
(i) Calculation of Value of firms by NI Approach:

Particulars X Ltd (`) Y Ltd (`)

EBIT (20% of `15,00,000) 3,00,000 3,00,000
Less: Interest on Debt 90,000 -
Profit Before Tax 2,10,000 3,00,000
Less: Tax @ 50% 1,05,000 1,50,000
Profit After Tax 1,05,000 1,50,000
Equity Capitalization rate 15% 15%
Market Value of Equity (PAT  Ke) 7,00,000 10,00,000
Value of debt 9,00,000 -
Total Value of the Firm 16,00,000 10,00,000

(ii) Values of the firm as per NOI Approach:

EBIT(1  t ) 3,00 ,000 (1  0.30)

Value of unlevered firm (Y Ltd) = =
Ko 0.15
= `10,00,000

Value of levered firm (X Ltd) = Value of unlevered firm + Debt × tax

= `10,00,000 + 9,00,000 × 50% = `14,50,000

This value of `14,50,000 can be bifurcated into Debt of `9,00,000 and Equity of `5,50,000.

(iii) Calculation of Ko under NOI Approach:

Y Ltd (Ko) = Ke = 15%

X Ltd (Ko) = KeWe + KdWd

= 19.1% × 5,50 ,000 + 5% × 9 ,00 ,000 = 10.34%
14 ,50 ,000 14 ,50 ,000
Or
EBIT(1 t )
X Ltd (Ko) = × 100
V
3 ,00 ,000(1  0 .50 )
= × 100 = 10.34%
14 ,50 ,000

Working Notes:

Calculation of Ke of X Ltd:
Earning for Equity
Ke = Market value of Equity
× 100

(3,00,000−90,000) (1−0.50)
= × 100 = 19.10%
5,50,000

Solution 2

NOI 3,60,000
(a) Value of the Alpha Ltd. = Ko
= 18%
= `20,00,000

Value of Shares of Alpha Ltd. = 50% of `20,00,000 = `10,00,000

 TEST BOOK 42
(i) Return on Shares on Alpha Ltd
Particulars `
Net Operating income 3,60,000
Less: Interest on Debt @ 8% on `10,00,0,00 (50% of `20,00,000) 80,000
Earnings for Equity Investors 2,80,000
Return on 2% Shares (2% of `2,80,000) 5,600

2,80,000
(ii) Implied required rate of return on Equity = × 100 = 28%
10,00,000

(b) (i) Return on Shares on Beta Ltd

Particulars `
Net Operating income 3,60,000
Less: Interest on Debt @ 8% on `4,00,0,00 (20% of `20,00,000) 32,000
Earnings for Equity Investors 3,28,000

Value of Shares of Beta Ltd. = 80% of `20,00,000 = `16,00,000

3,28,000
Implied required rate of return on Equity = 16,00,000
× 100 = 20.50%

(ii) It is lower than the Alpha Ltd. because Beta Ltd. uses less debt in its capital structure. As the equity
capitalisation is a linear function of the debt-to-equity ratio when we use the net operating income approach,
the decline in required equity return offsets exactly the disadvantage of not employing so much in the way of
“cheaper” debt funds.

Solution 3
Statement of Value of Firm and Cost of Capital

Particulars All equity 30% Debt 50% Debt

Earnings before interest and tax 4,00,000 4,00,000 4,00,000
Less: Interest @ 10% of `6,00,000 or - 60,000 -
@ 12% of `10,00,000 - - 1,20,000
Earning available for Equity 4,00,000 3,40,000 2,80,000
÷ Ke 16% 17% 20%
Value of Equity (E) [PBT ÷ Ke] 25,00,000 20,00,000 14,00,000
Value of Debt (D) - 6,00,000 10,00,000
Value of Firm (V) 25,00,000 26,00,000 24,00,000
Ko (EBIT ÷ V) 16% 15.38% 16.67%

Decision: Company should opt for 30% debt finance having higher Value of firm and lower Ko.

Solution 4

(a) Various calculation without tax:

Market Value of firms:

Market Value of B Ltd. (VUL) = EBIT ÷ Ke

= `18,00,000 ÷ 18% = `1,00,00,000

Market Value of A Ltd. (VL) = Value of unlevered = `1,00,00,000

Equity Capitalization Rate:

 TEST BOOK 43
Equity Capitalization Rate (B Ltd.) = 18% (given in the question)

Equity Capitalization Rate (A Ltd.) = (EBIT – I) ÷ *E (Value of Equity)

= (`18,00,000 – 12% × `54,00,000) ÷ `46,00,000
= 25.04%

*Value of Equity (E) of A Ltd. = Value of Firm – Debt

= `1,00,00,000 - `54,00,000 = `46,00,000

Weighted Average Cost of Capital:

Weighted Average Cost of Capital (B Ltd.) = Ke = Ko = 18%

Weighted Average Cost of Capital (A Ltd.) = EBIT ÷ V (Value of Firm)

= `18,00,000 ÷ `1,00,00,000 = 18%

(b) Various calculation with tax:

Market Value of firms:

Market Value of B Ltd. (VUL) = EBIT (1 - t) ÷ Ke or Ko

= `18,00,000 (1 – 0.40) ÷ 18% = `60,00,000

Market Value of A Ltd. (VL) = Value of unlevered + Debt × Tax

= `60,00,000 + `54,00,000 × .4 = `81,60,000

Equity Capitalization Rate:

Equity Capitalization Rate (B Ltd.) = 18% (given in the question)

Equity Capitalization Rate (A Ltd.) = (EBIT – I) (1 - t) ÷ *E (Value of Equity)

= (`18,00,000 – 12% × `54,00,000) (1 – .4) ÷ `27,60,000
= 25.04%

*Value of Equity (E) of A Ltd. = Value of Firm – Debt

= `81,60,000 - `54,00,000 = `27,60,000

Weighted Average Cost of Capital:

Weighted Average Cost of Capital (B Ltd.) = Ke = Ko = 18%

Weighted Average Cost of Capital (A Ltd.) = EBIT (1 - t) ÷ V (Value of Firm)

= `18,00,000 (1 – 0.4) ÷ `81,60,000
= 13.24%
 TEST BOOK 44
TEST 10 – DEVIDEND DECISIONS
Question 1

AB Engineering ltd. belongs to a risk class for which the capitalization rate is 10%. It currently has outstanding
10,000 shares selling at `100 each. The firm is contemplating the declaration of a dividend of `5 per share at
the end of the current financial year. It expects to have a net income of `1,00,000 and has a proposal for making
new investments of `2,00,000.

Required:
1. Calculate value of firm when dividends are not paid.
2. Calculate value of firm when dividends are paid.
(10 Marks)

Question 2

The following information is supplied to you:

Total Earnings `2,00,000

No. of equity shares (of `100 each) 20,000
Dividend paid `1,50,000
Price/Earnings ratio 12.5

Applying Walter’s Model:

1. Ascertain whether the company is following an optimal dividend policy.

2. Find out what should be the P/E ratio at which the dividend policy will have no effect on the value of the
share.
3. Will your decision change, if the P/E ratio is 8 instead of 12.5?
(10 Marks)

Question 3

With the help of following figures calculate the market price of a share of a company by using:

1. Walter’s formula
2. Dividend growth model (Gordon’s formula)

Earning per share (EPS) `10

Dividend per share (DPS) `6
Cost of capital (k) 20%
Internal rate of return on investment 25%
Retention Ratio 40%

(5 Marks)

Question 4

The dividend payout ratio of H Ltd. is 40%. If the company follows traditional approach to dividend policy with
a multiplier of 9, what will be the P/E ratio.
(5 Marks)
 TEST BOOK 45
SOLUTION TEST 10
Solution 1

1. Value of the firm when dividends are not paid:

Step 1: Calculate price at the end of the period:

Ke = 10%, P₀ = `100, D₁ = 0

P1 +D1
Pₒ = 1+Ke

P1 +0
`100 = 1+0.10
or P1 = `110

Step 2: No. of shares required to be issued:

Funds requied−(E−D) 2,00,000−(1,00,000−0)

No. of shares ∆n = Price at end(P₁)
= 110

= 909.09 shares

Step 3: Calculation of value of firm:

(n+ Δn)P1 − I+E

nPo = 1+Ke

(10,000+909.09)110−2,00,000+1,00,000
nPo = (1+.10)
= `10,00,000

2. Value of the firm when dividends are paid:

Step 1: Calculate price at the end of the period:

Ke = 10%, P₀ = `100, D₁ = `5

P1 +D1
Pₒ = 1+Ke

P1 +5
`100 = 1+0.10
or P1 = `105

Step 2: No. of shares required to be issued:

Funds requied−(E−D) 2,00,000−(1,00,000−50,000)

No. of shares ∆n = Price at end(P₁)
= 105

= 1,428.57 shares
Step 3: Calculation of value of firm:

(n+ Δn)P1 − I+E

nPo = 1+Ke

(10,000+1,428.57)105−2,00,000+1,00,000
nPo = (1+.10)
= `10,00,000

Thus, it can be seen that the value of the firm remains the same in either case.

Solution 3
 TEST BOOK 46
1 1
1. Ke = = = 8%
PE 12.5

Total Earnings 2,00,000

r = Total Funds
× 100 = 20,000 Shares ×100 per share
× 100 = 10%

r > Ke, Therefore as per Walter model optimum dividend payout is Nil and company is paying dividend to
shareholders means company is not following optimum dividend policy.

2. The P/E ratio at which the dividend policy will have no effect on the value of the share is such at which
the ke would be equal to the rate of return (r) of the firm.

Ke = r = 10%
1 1
PE = Ke
= .10
= 10 times

3. If the P/E is 8 instead of 12.5, then the Ke which is the inverse of P/E ratio, would be 12.5:
1 1
Ke = = = 12.5%
PE 8

In such a situation Ke > r and optimum dividend payout will be 100%.

Solution 3

1. Walter’s formula:
r 0.25
D + (E−D) × 6 + (10−6) ×
Ke
P = Ke
= 0.20
0.20
= `55

2. Gordon’s formula (Dividend Growth model):

D1 6
Po = = = `60
Ke −g 0.20−0.10

G = b×r = 25% × .4 = 10%

Solution 4

Since the dividend payout ratio is 40%

D = 40% of E i.e. 0.4E

P = M (D + E/3) = 9 (D + E/3) = 9 (0.4E + E/3)

1.2E+E
P = 9 (0.4E + E/3) = 9( ) = 3 (2.2E) = 6.6E
3

MPS P 6.6E
P/E ratio = EPS
= E
= E
= 6.6times
 TEST BOOK 47
SAMPLE PAPER 1
Question 1 (a)

A factoring firm has offered a to buy it’s accounts receivables. The relevant information is given below.

(i) The current average collection period for the company's debts is 80 days and ½% of debtors default.
The factor has agreed to pay over money due, to the company after 60 days, and it will suffer losses of
any bad debts also.

(ii) Factor will charge commission @2%.

(iii) The company spends `1,00,000 p.a. on administration of debtor. These are avoidable cost.

(iv) Annual credit sales are `90,00,000. Total variable costs is 80% of sales. The company's cost of
borrowings is 15% per annum. Assume 365 days in a year.

Should the company enter into a factoring agreement?

(5 Marks)

Question 1 (b)

Book value of capital structure of B Ltd. is as follows:

Sources Amount
12% 6,000 Debentures @ `100 each `6,00,000
Retained earnings `4,50,000
4,500 Equity shares @ `100 each `4,50,000
`15,00,000

Currently the market value of debenture is `110 per debenture and equity share is `180 per share. The
expected rate of return to equity shareholder is 24% p.a. Company is paying tax @30%.
Calculate WACC on the basis of market value weights.
(5 Marks)

Question 1 (c)

X Ltd. is a manufacturing company. Current market price per share is `2,185. During the F.Y. 2020-21, the
company paid `140 as dividend per share. The company is expected to grow @12% p.a. for next four years,
then 5% p.a. for an indefinite period. Expected rate of return of shareholders is 18% p.a.

(i) Find out intrinsic value per share.

(ii) State whether shares are overpriced or underpriced.

Year 1 2 3 4 5
Discounting Factor@18% 0.847 0.718 0.608 0.515 0.436
(5 Marks)

Question 1 (d)
A garment trader is preparing cash forecast for first three months of calendar year 2021. His estimated sales
for the forecasted periods are as below:

January (` ‘000) February (` ‘000) March (` ‘000)

Total sales 600 600 800
 TEST BOOK 48
(i) The trader sells directly to public against cash payments and to other entities on credit. Credit sales are
expected to be four times the value of direct sales to public. He expects 15% customers to pay in the
month in which credit sales are made, 25% to pay in the next month and 58% to pay in the next to next
month. The outstanding balance is expected to be written off.
(ii) Purchase of goods are made in the month prior to sales and it amounts to 90% of sales and are made on
credit. Payments of these occur in the month after the purchase. No inventories of goods held.
(iii) Cash balance as on 1st January, 2021 is `50,000.
(iv) Actual sales for the last two months of calendar year 2020 are as below:

November (` ‘000) December (` ‘000)

Total sales 640 880

You are required to prepare a monthly cash budget for the three months from January to March, 2021.
(5 Marks)

Question 2
Following are the data in respect of ABC Industries for the year ended 31st March, 2021:

Debt to Total assets ratio : 0.40

Long-term debts to equity ratio : 30%
Gross profit margin on sales : 20%
Accounts receivables period : 36 days
Quick ratio : 0.9
Inventory holding period : 55 days
Cost of goods sold : `64,00,000

Balance Sheet

Liabilities ` Assets `
Equity Share Capital 20,00,000 Fixed Assets
Reserves & surplus Inventory
Long-term debts Accounts receivables
Accounts payable Cash
Total 50,00,000 Total

Required:
Complete the Balance Sheet of ABC Industries as on 31st March, 2021.

All calculations should be in nearest rupee. Assume 360 days in a year.

(10 Marks)

Question 3

Earnings before interest and tax of a company are `4,50,000. Currently the company has 80,000 equity shares
of `10 each, retained earnings of `12,00,000. It pays annual interest of `1,20,000 on 12% Debentures. The
company proposes to take up an expansion scheme for which it needs additional fund of `6,00,000. It is
anticipated that after expansion, the company will be able to achieve the same rate of return on investment as
at present. It can raise fund either through debts at rate of 12% p.a. or by issuing Equity shares at par. Tax rate
is 40%.

Required:

Compute the earning per share if:

(a) The additional funds were raised through debt.

(b) The additional funds were raised by issue of Equity shares.
 TEST BOOK 49

Advise whether the company should go for expansion plan and which sources of finance should be preferred.
(10 Marks)

Question 4

Information of A Ltd. is given below:

 Earnings after tax : 5% of sales

 Income tax rate : 50%
 Degree of Operating leverage : 4 times
 10% Debenture in capital structure : `3 lakhs
 Variable costs : `6 lakhs

Required:

(i) From the given data complete following statement:

Sales XXXX
Less: Variable Costs `6,00,000
Contribution XXXX
Less: Fixed costs XXXX
EBIT XXXX
Less: Interest expenses XXXX
EBT XXXX
Less: Income tax XXXX
EAT XXXX

(ii) Calculate Financial Leverage and Combined Leverage.

(iii) Calculate percentage change in earning per share, if sales increased by 5%.
(10 Marks)
 TEST BOOK 50
SOLUTION SAMPLE PAPER 1
Solution 1 (a)

Statement of Evaluation
Particulars `
(A) Savings:
Saving in administration cost 1,00,000
Saving in bad debts (0.5% of 90,00,000) 45,000
*Saving in cost of debtors (90,00,000 × 80% × 80 – 60/365 × 15%) 59178
Total (A) 2,04,178
(B) Cost:
Annual charges (2% of 90,00,000) 1,80,000
Total (B) 1,80,000
Net Benefit (A - B) 24,178

*Presently, the debtors of the company pay after 80 days. However, the factor has agreed to pay after 60 days
only. So, the investment in Debtors will be reduced by 20 days.

Conclusion: Yes, company should enter into factoring agreement.

Solution 1 (b)

Statement of WACC (Market Value Weights)

Capital Structure Amount Weight Specific Cost Cost of Capital
12% Debentures 6,60,000 0.449 0.0764 0.0343
Equity Fund including Retained 8,10,000 0.551 0.1333 0.0734
earning
Total 14,70,000 1.000 WACC 0.1077

WACC (Ko) = 0.1077 or 10.77%

Working Notes:

(1) Calculation of Market Value:

Market value of debenture = (`6,00,000 ÷ `100) × `110 = `6,60,000

Market value of Equity and Retained earnings:

= (`4,50,000 ÷ `100) × `180 = `8,10,000

(2) Calculation of Ke:

D1 24% of 100
Ke = × 100 = = 13.33%
P0 180

(3) Calculation of Kd:

I (1  t ) 12% of 100 (1  0.3)
Kd = × 100 = × 100 = 7.64%
NP 110

Solution 1 (c)

(i) Calculation of Intrinsic Value of Share

Year Expected benefits PVF @ 18% DCF
1 140.00 + 12% = `156.80 0.847 132.81
2 156.80 + 12% = `175.62 0.718 126.10
3 175.62 + 12% = `196.69 0.608 119.59
 TEST BOOK 51
4 196.69 + 12% = `220.29 0.515 113.45
(5 to  ) P4 = `1,779.27 0.515 916.32

Present value of all future benefits or Intrinsic value of Share `1,408.27

D5 220.29 + 5%
P4 = Ke −g
= 18% − 5%
= `1,779.27

(ii) Intrinsic value of share is `1,408.27 as compared to latest market price of `2,185. Market price of a share
is overpriced by `776.73.

Solution 1 (d)

Cash Budget
(From January to March, 2021)
Particulars January February March
Opening Balance 50,000 1,74,960 3,55,280
Cash Sales & Debtors Collection 6,64,960 7,20,320 6,54,400
Total A 7,14,960 8,95,280 10,09,680
Payments to creditors (90% of sales) 5,40,000 5,40,000 7,20,000
Total B 5,40,000 5,40,000 7,20,000
Closing balance (A - B) 1,74,960 3,55,280 2,89,680

Working Note: Cash Sales and Collection from Debtors:

(` ‘000)
Cash Sales Credit Sales From Debtors Total
Month Sales
20% 80% 15% 25% 58% Collection
November 640 128 512 76.8 - - -
December 880 176 704 105.6 128 - -
January 600 120 480 72 176 296.96 664.96
February 600 120 480 72 120 408.32 720.32
March 800 160 640 96 120 278.4 654.4

Solution 2

Balance Sheet
Liabilities ` Assets `
Equity Share Capital 20,00,000 Fixed Assets 30,32,222
Reserves & surplus 10,00,000 Inventory 9,77,778
Long-term debts 9,00,000 Accounts receivables 8,00,000
Accounts payable 11,00,000 Cash 1,90,000
Total 50,00,000 Total 50,00,000

Working Notes:

Inventory holding period

1. Inventory = COGS ×
360
= `64,00,000 × 55/360 = `9,77,778

2. Sales = COGS ÷ COGS ratio

= `64,00,000 ÷ 80% (100 – G.P. ratio) = `80,00,000

Account receivable s period

3. Debtors = Sales ×
360
= `80,00,000 × 36/360 = `8,00,000

4. Debt:
 TEST BOOK 52
Debt ( Long  term debt  Accounts payables )
Debt to Total asset = = 40%
Total Asset
Debt = 40% of Total Assets
= `50,00,000 × 40% = `20,00,000

Note: In debt we are considering total debt i.e. Long-term debt and Accounts payables.

5. Equity Fund = Equity Share Capital + Reserve and surplus

= Total Liabilities – Debt
= `50,00,000 – `20,00,000 = `30,00,000

Reserve and surplus = Equity fund – Equity share capital

= `30,00,000 – `20,00,000 = `10,00,000

6. Long-term debt:
Long  term debt
Long-term debt to equity= = 30%
Equity
Long-term debt = 30% of Equity
= 30% of `30,00,000 = `9,00,000

Accounts payables = Debt – Long-term debt

= `20,00,000 – `9,00,000 = `11,00,000

Current assets  Inventorie s

7. Quick Ratio = = 0.9
Current liabilitie s

Current assets – `9,77,778 = 0.9 × `11,00,000

Current Assets = `9,90,000 + `9,77,778 = `19,67,778

Cash = Current assets – Inventories – Accounts receivables

= `19,67,778 - `9,77,778 - `8,00,000 = `1,90,000

8. Fixed assets = Total assets – Current assets

= `50,00,000 – `19,67,778 = `30,32,222

Solution 3

Statement of EPS
Alternatives
Particulars
Debt Plan (i) Equity Plan (ii)
Earnings before interest and tax @ 15% of `36,00,000 5,40,000 5,40,000
Less: Interest:
Existing 1,20,000 1,20,000
New (12% on `6,00,000) 72,000 -
EBT 3,48,000 4,20,000
Less: Tax @ 40% 1,39,200 1,68,000
EAT 2,08,800 2,52,000
÷ No. of Equity shares
Existing 80,000 80,000
New - 60,000
EPS `2.61 `1.80

Advise to the company: Since EPS after expansion under debt plan is higher (`2.61) than Existing EPS (`2.475),
company should go for expansion plan and choose debt source of finance.
 TEST BOOK 53

EPS before expansion =

EBIT  I 1  T  = 4 ,50 ,000  1 ,20 ,000  1  0.4  = `2.475
N 80 ,000
Working notes:

1. Calculation of capital employed before expansion plan:

Equity share capital (80,000 shares × `10) `8,00,000

Retained earnings `12,00,000
Debentures (`1,20,000/12%) `10,00,000

Total capital employed `30,00,000

2. Return on capital employed (ROCE) or Return on Investment:

EBIT 4 ,50 ,000

ROCE = × 100 = × 100 = 15%
Capital Employed 30 ,00 ,000

3. Capital employed after expansion = `36,00,000 (`30,00,000 + `6,00,000)

Solution 4
(i) Statement of EAT
Particulars `
Sales 12,00,000
Less: Variable Costs 6,00,000
Contribution 6,00,000
Less: Fixed costs 4,50,000
EBIT 1,50,000
Less: Interest expenses @ 10% of `3 lakhs 30,000
EBT 1,20,000
Less: Income tax 60,000
EAT @5% of `12,00,000 `60,000

EBIT 1 ,50 ,000

(ii) Financial Leverage = = = 1.25 times
EBT 1 ,20 ,000

Combined Leverage = OL × FL = 4 × 1.25 = 5 times

(iii) % change in EPS = % change in Sales × CL = 5% × 5 = 25% Increased

Working Notes:

Contributi on Contributi on
(a) Operating Leverage = = = 4
EBIT Contributi on  Fixed cos t
Contribution = 4 Contribution – 4 Fixed cost
- 3 Contribution = - 4 Fixed cost
¾ Contribution = Fixed cost

Contribution = Sales – Variable cost = Sales – `6,00,000

∴ Fixed cost = ¾ or 75% of contribution = 75% (Sales - `6,00,000)

= 75% Sales - `4,50,000

(b) EAT = 5% of Sales

EBT = EAT ÷ (1 - t) = 5% Sales ÷ (1 – 0.5)
= 10% Sales
 TEST BOOK 54
(c) EBT = Sales – Variable cost – Fixed cost – Interest
10% Sales = Sales - `6,00,000 – (75% Sales - `4,50,000) - `30,000
10% Sales = Sales - `6,00,000 – 75% Sales + `4,50,000 - `30,000
10% Sales = 25% Sales - `1,80,000
15% Sales = `1,80,000

Sales = `1,80,000 ÷ 15% = `12,00,000

(d) EBT = 10% of Sales = 10% of `12,00,000

= `1,20,000

(e) EBIT = EBT + Interest = `1,20,000 + `30,000

= `1,50,000

(f) Fixed cost = 75% of Contribution = 75% of `6,00,000

= `4,50,000
 TEST BOOK 55
SAMPLE PAPER 2
Question 1 (a)

Following are the information and ratios are given for W limited for the year ended 31st March, 2022:

Equity Share Capital of `10 each : `10 Lakhs

Reserves & Surplus to Shareholder’s Fund : 0.50
Sales/ Shareholders’ Fund : 1.50
Current Ratio : 2.50
Debtors Turnover Ratio : 6.00
Stock Velocity : 2 Months
Gross profit Ratio : 20%
Net Working Capital Turnover Ratio : 2.50

You are required to calculate:

(1) Shareholders’ Fund

(2) Stock
(3) Debtors
(4) Current Liabilities
(5) Cash Balance

(5 Marks)

Question 1 (b)

Balance sheet of X Ltd for the year ended 31st March, 2022 is given below:
(` in lakhs)
Liabilities Amount Assets Amount
Equity Shares `10 each 200 Fixed Assets 500
Retained Earnings 200 Raw Materials 150
11% Debentures 300 WIP 100
Public Deposits (Short-term) 100 Finished Goods 50
Trade Creditors 80 Debtors 125
Bills Payable 100 Cash and Bank 55
980 980

Calculate the amount of maximum permissible bank finance under three methods as per Tandon
Committee lending norms.

Total core current assets are assumed to be `30 Lakhs.

(5 Marks)

Question 2

Details of a company for the year ended 31st March, 2022 are given below:

Sales : `86,00,000
Profit Volume (P/V) Ratio : 35%
Fixed Cost excluding interest expense : `10,00,000
10% Debt : `55,00,000
Equity Share Capital of `10 each : `75,00,000
Income Tax Rate : 40%

Required:
(1) Determine company’s Return on Capital Employed (Pre-tax) and EPS.
 TEST BOOK 56
(2) Does the company have a favourable financial leverage?
(3) Calculate operating and combined leverage of the company.
(4) Calculate percentage change in EBIT, if sales increases by 10%
(5) At what level of sales, the Earning before tax (EBT) of the company will be equal to zero?
(10 Marks)

Question 3

Alpha Limited is a manufacturer of computers. It wants to introduce artificial intelligence while making
computers. The estimated annual saving from introduction of the artificial intelligence (AI) is as follows:

 Reduction of five employees with annual salaries of `3,00,000 each

 Reduction of `3,00,000 in production delays caused by inventory problem.
 Reduction in lost sales `2,50,000 and
 Gain due to timely billing `2,00,000

The purchase price of the system for installation of artificial intelligence is `20,00,000 and installation cost
is `1,00,000. 80% of the purchase price will be paid in the year of purchase and remaining will be paid in next
year.
The estimated life of the system is 5 years and it will be depreciated on a straight-line basis. However, the
operation of the new system requires two computer specialists with annual salaries of `5,00,000 per person.
In addition to above, annual maintenance and operating cost for five years are as below:
(Amount in `)
Year 1 2 3 4 5
Maintenance & Operating Cost 2,00,000 1,80,000 1,60,000 1,40,000 1,20,000

Maintenance and operating cost are payable in advance. The company’s tax rate is 30% and its required rate
of return is 15%.

Year 1 2 3 4 5
PVIF0.10,t 0.909 0.826 0.751 0.683 0.621
PVIF0.12,t 0.893 0.797 0.712 0.636 0.567
PVIF0.15,t 0.870 0.756 0.658 0.572 0.497

Evaluate the project by using Net Present Value and Profitability Index.
(10 Marks)

Question 4

The particulars related to Raj Ltd. for the year ended 31st March, 2022 are given as follows:

Output (units at normal capacity) 1,00,000

Selling price per unit `40
Variable cost per unit `20
Fixed cost `10,00,000

The capital structure of the company as on 31st March, 2022 is as follows:

Particulars `
Equity Share Capital (1,00,000 shares of `10 each) Reserves 10,00,000
and Surplus 5,00,000
Current Liabilities 5,00,000
Total 20,00,000

Raj Ltd. has decided to undertake an expansion project to use the market potential that will involve `20,00,000.
The company expects an increase in output by 50%. Fixed cost will be increased by `5,00,000 and variable
 TEST BOOK 57
cost per unit will be increased by 15%. The additional output can be sold at the existing selling price without
any adverse impact on the market.

The following alternative schemes for financing the proposed expansion program are planned:

Alternative Debt Equity Shares

1 `5,00,000 Balance
2 `10,00,000 Balance
3 `14,00,000 Balance

Slab wise interest rate for fund borrowed is as given follows:

Fund Limit Applicable Interest Rate

Upto `5,00,000 10%
Over `5,00,000 and upto `10,00,000 15%
Over `10,00,000 20%

Current market price per share is 200.

Find out which of the above mentioned alternatives would you recommend for raj Ltd. with reference
to the EPS, assuming a corporate tax rate is 40%?
(10 Marks)
Question 5

A company issues:

 15% convertible debentures of `100 each at par with a maturity period of 6 years. On maturity, each
debenture will be converted into 2 equity shares of the company. The risk-free rate of return is 10%,
market risk premium is 18% and beta of the company is 1.25. The company has paid dividend of `12.76
per share. Five year ago, it paid dividend of `10 per share. Flotation cost is 5% of issue amount.

 5% preference shares of `100 each at premium of 10%. These shares are redeemable after 10 years at
par. Flotation cost is 6% of issue amount.

Assuming corporate tax rate is 40%.

(a) Calculate the cost of convertible debentures using the approximation method.
(b) Use YTM method to calculate cost of preference shares.

Year 1 2 3 4 5 6 7 8 9 10
PVIF0.03,t 0.971 0.943 0.915 0.888 0.863 0.837 0.813 0.789 0.766 0.744
PVIF 0.05,t 0.952 0.907 0.864 0.823 0.784 0.746 0.711 0.677 0.645 0.614
PVIFA0.03,t 0.971 1.913 2.829 3.717 4.580 5.417 6.230 7.020 7.786 8.530
PVIFA0.05,t 0.952 1.859 2.723 3.546 4.329 5.076 5.786 6.463 7.108 7.722

Interest rate 1% 2% 3% 4% 5% 6% 7% 8% 9%
FVIFi,5 1.051 1.104 1.159 1.217 1.276 1.338 1.403 1.469 1.539
FVIFi,6 1.062 1.126 1.194 1.265 1.340 1.419 1.501 1.587 1.677
FVIFi,7 1.072 1.149 1.230 1.316 1.407 1.504 1.606 1.714 1.828
(10 Marks)
 TEST BOOK 58
SOLUTION SAMPLE PAPER 2
Solution 1 (a)

(1) Shareholders’ Fund = Equity Share Capital + Reserve and Surplus

= `10 Lakhs + 0.50 Shareholders’ Fund

0.50 Shareholders’ Fund = `10 Lakhs

Shareholders’ Fund = `10 Lakhs ÷ 0.50 = `20,00,000

Reserve and Surplus

Shareholders′ Fund
= 0.50 or Reserve & Surplus = 0.50 Shareholders’ Fund

(2) Stock = COGS × Stock velocity/12

= `24,00,000 × 2/12 = `4,00,000

Sales
Shareholders′ Fund
= 1.50 or Sales = 1.50 Shareholders’ Fund

Sales = 1.50 × `20,00,000 = `30,00,000

COGS = Sales – Gross Profit

= `30,00,000 – 20% = `24,00,000

(3) Debtors = Annual Credit Sales ÷ Debtors Turnover Ratio

= `30,00,000 ÷ 6 = `5,00,000

(4) Current Liabilities:

Current Ratio = CA ÷ CL = 2.50

Current Asset = 2.50 CL
Sales
= 2.50
Net Working Capital
Net Working Capital = Sales ÷ 2.50 = `30,00,000 ÷ 2.50
= `12,00,000

CA – CL = `12,00,000
2.5 CL – CL = `12,00,000
Current Liabilities = `12,00,000 ÷ 1.5 = `8,00,000

(5) Cash Balance = Current Asset – Debtors – Stock

= `20,00,000 - `5,00,000 - `4,00,000

= `11,00,000

Current Asset = 2.5 CL

= 2.5 × 8,00,000 = `20,00,000

Solution 1 (b)

Calculation of MPBF:

Method 1 = 75% (CA - CL) = 75% (480 – 280) = `150 Lakhs

Method 2 = (75% CA) – CL = (75% 480) – 280 = `80 lakhs

 TEST BOOK 59
Method 3 = (75% CA other than core CA) – CL
= 75% (480 – 30) – 280 = `57.50 Lakhs

Current Assets = Raw Materials + WIP + Finished Goods + Debtors + Cash and Bank
= 150 + 100 + 50 + 125 + 55 = `480 Lakhs

Current Liabilities = Public deposit (Short term) + Trade Creditors + Bills Payable
= 100 + 80 + 100 = `280 Lakhs

Solution 2
EBIT 20 ,10 ,000
(1) ROCE = ×100 = ×100 = 15.46%
Capital Employed 55,00 ,000  75,00 ,000

Statement of EPS
Particulars `
Sales 86,00,000
Less: Variable cost @ of 65% (100 – P/V ratio) of sales 55,90,000
Contribution 30,10,000
Less: Fixed costs 10,00,000
EBIT 20,10,000
Less: Interest @ 10% of 55,00,000 5,50,000
EBT 14,60,000
Less: Income Tax @ 40% 5,84,000
EAT 8,76,000
÷ Number of Equity Shares ÷ 7,50,000
EPS 1.168

(2) ROCE is 15.46% and Interest on debt is 10%, hence, it has a favourable financial leverage.

(3) Calculation of Operating and Combined leverages:

Contributi on 30 ,10 ,000
Operating Leverage = = = 1.497
EBIT 20 ,10 ,000

Contributi on 30 ,10 ,000

Combined Leverage = = = 2.062
EBT 14 ,60 ,000

(4) Operating leverage is 1.497. So if sales is increased by 10% then EBIT will be increased by 1.497 × 10
i.e. 14.97% (approx.)

(5) EBT = Sales – Variable cost – Fixed cost – Interest

Nil = Sales – 65% sales – 10,00,000 – 5,50,000
35% of sales = 15,50,000
Sales = `44,28,571

Solution 3

(1) Net Present value (NPV)

Year Particulars ` PVIF @ 15% PV
0 Initial Outflows:
80% of Purchase price (20,00,000 × 80%) (16,00,000) 1.000 (16,00,000)
Installation cost (1,00,000) 1.000 (1,00,000)
1 20% of Purchase Cost (4,00,000) 0.870 (3,48,000)
PV of Outflows 20,48,000
0 Maintenance & Operating cost for year 1 (2,00,000) 1.000 (2,00,000)
1 CFAT 8,81,000 0.870 7,66,470
2 CFAT 8,95,000 0.756 6,76,620
 TEST BOOK 60
3 CFAT 9,09,000 0.658 5,98,122
4 CFAT 9,23,000 0.572 5,27,956
5 CFAT 10,37,000 0.497 5,15,389
PV of Inflows 28,84,557
NPV 8,36,557

Advice: Accept the proposal having positive NPV.

(2) Profitability Index = PV of Inflows ÷ PV of Outflows

= 28,84,557 ÷ 20,48,000 = 1.41

Advice: Accept the proposal having PI higher than 1.

Working Note:
Statement of CFAT
Particulars 1 2 3 4 5
Saving in employees salaries 15,00,000 15,00,000 15,00,000 15,00,000 15,00,000
(`3,00,000 × 5)
Add: Reduction in prod. delays 3,00,000 3,00,000 3,00,000 3,00,000 3,00,000
Add: Reduction in lost sales 2,50,000 2,50,000 2,50,000 2,50,000 2,50,000
Add: Gain due to timely billing 2,00,000 2,00,000 2,00,000 2,00,000 2,00,000

Less: Salaries computer specialist (10,00,000) (10,00,000) (10,00,000) (10,00,000) (10,00,000)

(`5,00,000 × 2)
Less: Maintenance & Op. cost (2,00,000) (1,80,000) (1,60,000) (1,40,000) (1,20,000)
Less: Depreciation (4,20,000) (4,20,000) (4,20,000) (4,20,000) (4,20,000)
(21,00,000 ÷ 5 years)
PBT 6,30,000 6,50,000 6,70,000 6,90,000 7,10,000
Less: Tax @ 30% (1,89,000) (1,95,000) (2,01,000) (2,07,000) (2,13,000)
PAT 4,41,000 4,55,000 4,69,000 4,83,000 4,97,000
Add: Depreciation 4,20,000 4,20,000 4,20,000 4,20,000 4,20,000
Add: Maint. & Op. cost (accrual) 2,00,000 1,80,000 1,60,000 1,40,000 1,20,000
Less: Maint. & Op. cost (Cash) (1,80,000) (1,60,000) (1,40,000) (1,20,000) -
CFAT 8,81,000 8,95,000 9,09,000 9,23,000 10,37,000

Solution 4
Statement of EPS
Alternatives
Particulars
1 2 3
Expected output in units (1,00,000 + 50%) 1,50,000 1,50,000 1,50,000
Sales @ `40 per unit 60,00,000 60,00,000 60,00,000
Less: Variable Cost @ `17 (`20 - 15%) per unit 25,50,000 25,50,000 25,50,000
Contribution 34,50,000 34,50,000 34,50,000
Less: Fixed Cost (`10,00,000 + `5,00,000) 15,00,000 15,00,000 15,00,000
Earnings before interest and tax 19,50,000 19,50,000 19,50,000
Less: Interest:
@ 10% on first `5,00,000 50,000 50,000 50,000
@ 15% on `5,00,001 to `10,00,000 - 75,000 75,000
@ 20% on above `10,00,000 - - 80,000
EBT 19,00,000 18,25,000 17,45,000
Less: Tax @ 40% 7,60,000 7,30,000 6,98,000
EAT 11,40,000 10,95,000 10,47,000
÷ No. of Equity shares
Existing 1,00,000 1,00,000 1,00,000
New 7,500 5,000 3,000
(15,00,000/200) (10,00,000/200) (6,00,000/200)
EPS `10.60 `10.43 `10.17
 TEST BOOK 61
Decision: The earning per share is higher in alternative I i.e. if the company finance the project by raising debt
of `5,00,000 & issue equity shares of `15,00,000. Therefore, the company should choose this alternative to
finance the project.

Solution 5

(a) Calculation of cost of Convertible Debentures using Approximation method:

RV−NP 130.58−95
I (1 − t) + 15 (1 − 0.40) +
Kd = RV+NP
n
× 100 = 130.58+95
6
× 100
2 2
= 13.24%

Working Notes:

Determination of Redemption value:

Higher of
(i) The cash value of debentures = `100

(ii) Value of equity shares = 2 shares × `48.72 (1 + 0.05)6 = `130.58

`130 will be taken as redemption value as it is higher than the cash option and attractive to the investors.

Calculation of Value of Share today:

D1 12.76 (1+0.05)
P0 = = = `48.72
Ke −g 32.50%−5%

Ke = Rf + β (Rm - Rf) = 10% + 1.25 × 18% = 32.50%

5 12.76
g = √ = 5% or
10.00

g = 12.76 ÷ 10.00 = 1.276 (5% for 5 year; given in interest rate table)

(b) Calculation of Cost of Preference shares using YTM method::

Calculation of NPV at two discount rates:

Present Value Present Value

Year Cash Flow
3% DCF 5% DCF
0 103.40 1.000 (103.40) 1.000 (103.40)
1 - 10 5 8.530 42.65 7.722 38.61
10 100 0.744 74.40 0.614 61.40
NPV +13.65 -3.39

NPVL 13 .65
IRR/Kd = LR + × (H - L) = 3% + × (5% - 3%)
NPVL  NPVH 13 .65  (  3.39 )
= 4.60%

Working Note:

Net Proceeds = Issue Price – Flotation Cost

= (100 + 10% Premium) – 6% = `103.40